Implications of the TCJA on Choice of Entity
With changes to C corporation tax rates and pass-through entity deductions, the TCJA has opened opportunities for business owners considering reclassification of their business entity. It’s also added a new layer of complexity, especially since changes to an entity’s structure must have a substantial non-tax motive, and the IRS has not yet issued formal guidance on the impacts of the new rules.
Before making a decision on entity classification, every business owner should consult their advisor, and you’ll find in this article some main points you should consider when you do.
The earnings of C corporations are subject to double taxation. First, the corporate-level tax on earnings, and second, at the individual level once distributed. If a corporation pays out qualified dividends, they’re usually taxed at 15% or 20% and potentially the additional investment income tax of 3.8%. The second level of tax can be deferred because the tax is not incurred until dividends are distributed. However, there are also potential reductions in the value of that tax deferral for undistributed corporate earnings such as the personal holding company tax, accumulated earnings rules, and reasonable compensation rules.
Key Corporate Tax Changes:
- The corporate tax rate has been permanently reduced from 35% to 21%.
- There is no special rate for personal service corporations (21% applies).
- The corporate alternative minimum tax (AMT) has been repealed.
- Dividend received deduction percentages have been reduced. The 80% deduction is reduced to 65% for 20%+ owned corporations, and the 70% deduction is reduced to 50% for <20% owned corporations.
- Net Operating Losses (NOLs) are limited to 80% of taxable income. The two-year carryback rule was repealed, and now it can be carried forward indefinitely.
- There is now expanded availability of the cash basis method of accounting.
- State and local taxes (SALT) continue to be fully deductible (unlike the personal income tax reduction in the SALT area).
Now that the top corporate tax rate is 21%, income that is distributed as dividends to individuals, for example, is taxed at a combined rate of 44.8% (21% + 20% + 3.8% - corporate tax paid, individual rate on qualified dividends and the Medicare surtax), which is relatively close to the new top individual rate of 40.8% (including the Medicare surtax again). If corporate earnings are distributed, it appears the gap between the two rates has decreased substantially under the new law. However, rapidly-growing businesses that are raising capital or heavily reinvesting their cash may prefer C corporation status. With it, they’ll pay 21% rather than higher personal rates resulting from pass-through status of other entities. Although they will eventually have to pay taxes on future capital gains or qualified dividends, if the business is growing enough, the tax deferral (21% now, and capital gains or qualified dividends not taxed until years or decades in the future) may still be compelling.
- New lower rate on undistributed earnings leaves more after-tax dollars for reinvestment
- Potential to eliminate the 2nd level of tax if stock is §1202 “qualified small business stock”
- Ability to engage in tax-free reorganizations
- Double tax on distributed profits
- Tax traps such as the accumulated earnings tax and the tax on Personal Holding Companies
- The audit risk for “reasonable compensation” issues
- Easy to become a C corporation but difficult to get out
Consider the following implications of being a C corporation:
- Can deduct all state and local income and property taxes paid or accrued in carrying on a trade or business. Flow-through entities are limited to $10,000.
- Status may be considered for businesses that hold investment assets, and that income is taxed at a lower rate. However, be careful of the personal company holding tax and accumulated earning tax issues, which will likely take on greater significance with the changes in tax rates.
- Small businesses operating as C corporations may be able to offer “qualified small business stock.” If the stock is held for at least five years, all gain upon its sale is completely tax-free. S corporation (S Corp) shares and LLC membership interests cannot qualify for this tax-free gain.
- Can take advantage of 100% dividends received deduction against dividends from foreign subsidiaries that conduct active business in the US (Individuals and pass-through entities cannot take advantage of this).
- Consider the 70/30 split for reasonable compensation. 70% of income distributed as salary to the owner and 30% is retained within the corporation and distributed as a dividend.
Pass-Through Entity Types
Pass-through entities like S corporations, partnerships, or LLCs (Limited Liability Corporations) are taxed once, income is “passed through” and each owner reports their respective share of income. There is no tax on profits at the entity level. Sole proprietorships and pass-through (“disregarded”) entities that do not elect corporate status report income and expenses on the individual owner’s tax return. Income from pass-throughs is taxable to owners whether or not it is actually distributed from the entity. Pass-through entities have generally been taxed at lower rates than corporations due to lower rate structures for the individuals and the double taxation of the corporation earnings.
Under TCJA, owners of pass-through businesses are offered a 20% deduction for their “qualified trade or business income.” “Qualified trade or business” means any trade or business other than a specified service business.” This reduces their top marginal tax rate from 37% to 29.6% (37% x (1-20%)), making the real difference between tax treatment larger, or offsetting some of the nominal reduction in the difference between pass-through and corporate taxation.
How does this new consideration affect the choice of entity? In general, it seems that businesses looking to sell soon, or that take out substantial ongoing profits as cash flow, will tend towards opting for the pass-through business structure, since the net or aggregate rate is still lower for the individual taxpayer.
Those that operate in a specified service business and who have income above the phase-out threshold may not benefit from the deduction, and may consider restructuring.
Unfortunately, advice regarding this area of the new tax law should be given with a dose of caution. For example, one of the main areas of concern with regard to the new qualified trade or business income deduction relates to the definition of “specified” service trade or business. Is it possible to spin off parts of a specified service trade or business so that it might qualify for the 20% deduction for the non-specified service activities? We don’t know the answer.
- New lower overall tax burden vs. the distribution of C corporation profits (unless the entity qualifies as §1202 qualified small business stock)
- Pass-through of losses
- Partnerships have certain advantages:
- Flexibility in allocating tax benefits/burdens
- Possibility of asset basis step-upon transfer of interest or upon death (§754)
- Greater distribution flexibility
- S Corp owners can minimize self-employment taxes. Salaries are subject to self-employment taxes, but distributions are not
- No possibility on deferral of tax (currently taxed even if not distributed to owners)
- State and local taxes (SALT) on pass-through income subject to $10,000 cap
- S corporations:
- Restricted ownership
- Restricted distributions
- Must pay a “reasonable” salary
In addition to the income tax considerations in evaluating pass-through entity status versus C corporation status, there are potential estate planning considerations, so any conversion analysis should account for the estate and transfer tax possibilities and ramifications.