With all the changes in the taxation of businesses enacted under the 2017 Tax Cuts and Jobs Act (Act), many business owners wonder whether they need to revisit the business entity decisions they made when they organized their businesses. The changes under the new Act that are causing questions about optimal tax entity structure include reduction of the tax rate on C corporations to 21%, introduction of the new 20% deduction on qualified business income from pass-through entities, and the repeal of the corporate alternative minimum tax.
While business owners are wise to periodically challenge their entity elections, it is important to recognize that those who drafted this Act did the math and crafted provisions that result in roughly the same rate differences between C-corporations and pass-throughs as existed under the old regime.
Recall that C corporations have their earnings taxed once at the corporate level and taxed again when they are distributed to the shareholders at the individual level. Generally, all pass-through income is taxed once at the level of the individual owners.
Before the enactment of the recent law, C corporations paid a maximum rate of 35% at the corporate level and their shareholders paid a maximum of 23.8% on the distributed earnings (20% income tax on qualified dividends plus 3.8% of net investment income tax). After enactment of the new law, C corporations pay 21% on their earnings and their shareholders still pay a maximum of 23.8% on the distributed earnings. Under the old law, $1 of incremental income to a C corporation resulted in 35 cents of corporate tax and 15.5 cents of individual tax ([$1 – ($1 * 35%)] * 23.8%), for a total of 50.5 cents. Under the new law, $1 of income to a C corporation results in 21 cents of corporate tax and 18.8 cents of individual tax ([$1 – ($1 * 21%)] * 23.8%), for a total of 39.8 cents. Thus, under the new tax law, the effective incremental tax on $1 of C corporation earnings to the shareholders subject to maximum tax rates declines by 10.7 cents.
Before the new law, pass-through owners paid income tax at a maximum rate of 39.6%. Under the new law they will pay tax at a maximum rate of 37% and will be eligible for a new deduction of 20% of qualified business income. (There are many provisions of the new Act that may limit the applicability of the deduction, which you should review with your tax advisor.) Accordingly, $1 of incremental income to a pass-through entity resulted in 39.6 cents of tax, before the new law. Under the new law, $1 of income to a pass-through entity entitles the owner to a 20-cent deduction and the net is taxed at a maximum rate of 37%, yielding 29.6 cents of tax ([$1 – ($1 * 20%)] * 37%). The net effect of the new law on $1 of incremental pass-through income is a 10-cent reduction in tax (39.6 – 29.6). If the corporation does not qualify for the 20% deduction, the gap is only 2.6 cents.
This analysis, working with maximum tax brackets, shows that the new law has roughly the same reduction on the taxation of C corporation earnings as it does on those of pass-through entities. In general, the tax on $1 of earnings to a pass-through entity that qualifies for the 20% reduction is lower than its C-corporation counterpart by approximately 10 cents. Therefore, if a business owner had made a well-reasoned decision as to entity selection for an existing business before the new tax law, nothing in the new law would generally invalidate that decision. It is important to note that this analysis does not address the impact of state taxes. Many states tax C corporation income differently than pass-through income. The state tax impact of any entity selection decision should be reviewed with your tax advisor.
This is not to say that there will not be situations that will dictate a change in entity classification (perhaps for a temporary period) to take advantage of a specific opportunity.
For instance, the shareholders of an S corporation may have a need to retain significant earnings in the business for a few years to pay off debt, and may want to temporarily take advantage of the lower C corporation rate during this time. They could revoke their S election and file as a C corporation while they pay down the debt. If they would like to become an S corporation again, there is a minimum period of five years before the re-election can be made. Additionally, if built in gains are present when S corporation status is re-elected, the corporation will want to allow the 5-year built in gain recognition period to pass before liquidating assets.
Another example of a circumstance where a temporary switch to C corporation status by the owners of a pass-through entity might be beneficial is if the shareholders of an S corporation want to change accounting methods, and the change will result in the recognition of significant business income during a short window of time. Again, the temporary switch to C corporation status with the lower 21% tax rate may be beneficial. However, if the owners will be distributing cash during this period, there would not be a savings.
None of the above discussion of existing business entities is intended to limit consideration of all entity types when starting a new business. Since 1986, the tax landscape has made S corporations the default vehicle for most small business start-ups. But the new lower C corporation tax rate and the availability of the “Qualified Small Business Stock” provision that allows buyers of stock directly from a C corporation to eventually sell that stock tax free, may have tipped the scales for many start-ups to more seriously consider initially organizing as a C corporation.
One final reminder – if you would like to make an S election, in order for it to be effective January 1, 2018, it must be made by March 15, 2018.
Of course, there are lots of complicating factors underlying the strategies discussed above, and none of them should be undertaken without consultation of your tax advisor. The Clark Schaefer Hackett tax team stands ready to help you.