Does the New Tax Law Make Entity Selection More Complicated? (article)
The new corporate tax rate is one of the hallmarks of the tax legislation introduced as the Tax Cuts and Jobs Act (TCJA). At a flat 21 percent, it represents a double-digit decrease from the previous top rate of 35 percent. Pass-through entities, such as partnerships, LLCs, and sole proprietorships also benefit from reductions in their tax rates. The top individual tax rate drops from 39.6 percent to 37 percent and business owners may be able to take advantage of the new 20 percent deduction under Internal Revenue Code Section 199A on qualified business income. On its face it may appear that the corporate structure is the best option, however, you need to dig deeper to conclude on that.
Entity structuring involves more than comparing tax rates. If you are considering whether to restructure, it’s important to evaluate all of the factors involved. You may find that, even with the rate change, staying the course with your current structure may make the most sense for your business.
Evaluating Effective Tax Rates
Tax rates under the TCJA do not necessarily reflect the taxes a company would actually pay. Pass-through entities are subject to individual tax rates. Assuming that an owner is subject to the top 37 percent rate, can use the Section 199A deduction, and materially participates in the business, that individual’s effective tax rate would be 29.6 percent. Owners that do not materially participate in the business would be subject to the net investment income tax (NIIT), and may have slightly higher effective tax rates.
If structured as a corporation, a company’s effective tax rate would be a little higher due to the “double taxation” issue. C corporation dividends are subject to taxation at the shareholder level, so in essence business income is taxed twice, once at the C corporation level (21 percent) and again at the individual level (23.8 percent) when dividends are paid. This makes the effective federal tax rate for C corporations 39.8 percent, if all profits were distributed out as dividends.
Many companies opt to use the pass-through structure to avoid the double taxation issue, but there may be some situations where the double taxation issue is not as significant, or where double taxation does not outweigh the benefits of making the switch.
Why Tax Rates Aren’t Everything
As before the new tax legislation, size makes a big difference to the evaluation of entity selection. Small organizations—particularly those with gross income under $1 million—typically benefit the most from an S corporation structure. Small C corporations may not be subject to the full 39.8 percent tax rate because the dividend distributions could fall beneath the NIIT threshold, but rates would still likely be around 31 percent. Partnership effective tax rates are generally slightly higher than S Corporation rates, due to self-employment taxes.
Differences between effective tax rates narrow slightly as organizations get larger. Organizations may have effective tax rates closer together because owners may not be subject to the top individual tax rate or the NIIT.
Another factor is the type of business you operate. One of the key audiences that may be looking at making the entity structure change are pass-through entities that are ineligible to receive the qualified business income deduction under Section 199A. The law defines qualified business as any trade or business other than (a) one involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing or investment management services, or any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners; or (b) one involving the performance of services as an employee.
These so-called service organizations, particularly those with large business taxable income, may benefit more from the C corporation structure. For example, a business with $4 million in taxable income, that pays out $2.5 million in dividends, would have a lower C corporation effective tax rate than an S corporation or partnership due to the fact that the service organization could not use the Section 199A qualified business income deduction.
Other considerations about whether to restructure your business remain unchanged:
- Business owners who want to reinvest the majority of their earnings into their business may want to take a look at the C corporation structure. If owners are planning to exit their business in the near term, switching to a C corporation would not be as ideal because of the double taxation issue.
- Companies that want to expand their number of shareholders—perhaps because of growth opportunities or in an attempt to go public—may want to switch to a C corporation to avoid the S corporation limit on the number of shareholders.
- C corporations are also able to issue more than one type of stock as part of their stock compensation plans whereas S corporations are not. Another item to consider would be the potential exclusion of capital gain on the sale of C corporation stock that qualifies under Section 1202.
Each Decision is Highly Unique
It isn’t easy to determine whether your organization would be best served as an S corporation, other flow-through structure, or a C corporation. Entity selection depends on your unique facts and circumstances, your financial performance, and your end objectives for your business. A tax advisor who understands the nuances, benefits, and drawbacks of each entity type can help you determine whether restructuring makes sense for your business.
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