Before the passage of the Tax Cuts and Jobs Act (the “Tax Act”), deciding whether to conduct a business as a C corporation or in the form of a “flow-through” entity, such as a partnership, LLC , or an S corporation, used to be far more straightforward. However, due to changes brought forth under the new Tax Act, a business’s decision whether to use a flow-through entity or a C corporation is no longer a simple one. Under the new Tax Act, a business owner must now consider a number of factors when evaluating the type of entity that will be most advantageous to the business.
When the Tax Cuts and Jobs Act was signed into law on December 22, 2017, the Tax Act brought major changes to the US tax system. Most importantly, the corporate tax rate was reduced from 35% to a flat 21%. Additionally, the Alternative Minimum Tax was completely removed, and C corporations can benefit from deducting state and local taxes. For pass-through entities, income will still be taxed at ordinary income tax rates, and the Tax Act allows business owners to deduct 20% of their “qualified business income” (QBI), resulting in some pass-through entities being taxed on only 80% of their pass-through income.
Despite these benefits, the Tax Act eliminated a big deduction for pass-through entities by capping state and local tax deductions at $10,000. Additionally, the Tax Act only allows the full 20% QBI deduction on incomes up to $157,000 for an individual and $315,000 per family for “service businesses,” which are defined as health, law, accounting, performing arts, consulting, athletics, and financial services businesses. For some pass-through service entities with incomes exceeding $207,500 for an individual or $415,000 for a family, the 20% deduction may not be taken at all.
With more seemingly favorable tax benefits being provided to C-corporations compared to pass-through entities under the new Tax Act, many business owners may be motivated to either form or convert their businesses to C-corporations. However, before deciding on a C corporation, business owners should consider some pros and cons of using this structure versus a pass-through entity, where the individual owner of the entity is responsible for paying the business’s taxes.
One factor that a business should consider when evaluating entity options under the new Tax Act is whether the business intends to distribute earnings or retain its earnings. One drawback of using a C corporation is that it remains subject to two levels of taxation; one at the corporate level on earnings and the second at the shareholder level on dividends. So for a business that intends to distribute its income back to its owners, forming the business as a C corporation could push the combined federal tax rate as high as 36.8%, eroding some benefits of being a C corporation. However, if a business intends to reinvest its profits within the corporation, then forming itself as a C corporation may result in advantageous tax savings since no dividend taxation will apply and the corporate tax rate is capped at 21%.
Additionally, the business owner’s time horizon for exiting the business should be considered when evaluating entity type. When a company is sold in an asset sale, two taxes are imposed on a C corporation. The corporation is taxed when it sells its assets for cash, and it is taxed again if the corporation is liquidated and the stockholders exchange their shares for sale proceeds. So, if an owner intends to sell his or her business in the near future, structuring a business as a C corporation would not likely be advantageous. However, if the owner has no immediate plans to sell the company or if the owner has children who are taking over the business, then corporate tax concerns associated with an asset sale are less of a concern.
The changes under the new Tax Act are complex, and beyond evaluating earnings distributions or exit strategies businesses will also need to consider state and federal tax laws, alternative minimum tax implications, and whether the business needs to offset income through losses in future years. By considering all of these factors collectively under the guidance of legal and accounting professionals, a business owner can more confidently select an entity that maximizes his or her business’s tax savings under the new Tax Act.