Pass-Throughs Still the Preferred Choice of Entity in 2013 and Beyond

A number of commentators have suggested that since the maximum marginal individual federal income tax rate has risen to 39.6% and now exceeds the maximum marginal federal tax rate applicable to C Corporations of 35%, that it might be wise to convert pass-through entities (like partnerships, S Corporations and LLCs taxed as partnerships or S Corporations) to C Corporations or operate newly formed businesses through C Corporations.  However, if the business intends to distribute its earnings to its owners, there is a still a double tax effect on those distributions that make pass-through entities the preferred choice of entity in 2013 and beyond.   The effective tax rate on earnings of a C Corporation distributed as dividends to individuals that are in the highest marginal individual tax bracket is 50.47%* (35% maximum corporate rate + 20% maximum dividend rate + 3.8% tax on net investment income, including dividends) vs. 39.6% for pass-throughs, if the owners materially participate in the business or 43.4% for any owners that do not (39.6% maximum individual rate + 3.8% tax on net investment income).   Likewise, the same rate differentials will apply to C corporations which sell their assets versus a pass-through entity that sells its assets.

*This rate does not include state corporate taxes not imposed on pass-throughs.