By: Cory Vargo
The Tax Cuts and Jobs Act, passed in December of 2017, made major changes to the way C corporations and pass-through entities (e.g., S corporations and partnerships) are taxed under federal law. The most significant changes include a flat 21% tax rate on C corporation earnings and a new deduction of up to 20% of Qualified Business Income (QBI) for owners of businesses that are taxed as pass-through entities. Whether it be forming a new business or converting the entity type of an existing one, all relevant factors should be considered to ensure the most tax-efficient entity structure is implemented.
The most impactful factors to consider when making an entity choice decision under the new tax law include i) the extent to which business owners can benefit from the new 20% QBI deduction; ii) whether cash earnings will be reinvested in the business or largely distributed to the owners on a regular basis; and iii) immediate tax consequences triggered by a conversion transaction for an existing business.
Section 199A Qualified Business Income Deduction
The first item to consider is whether business owners will benefit from the QBI deduction, which can be as large as 20% of an individual’s income earned from qualified businesses that operate in pass-through form (e.g., S corporations and partnerships). To put this in perspective, an individual that is taxed at the highest federal income tax rate of 37% will face a marginal federal income tax rate as low as 29.6% on their QBI, assuming the full 20% deduction is allowable.
The 20% deduction generally applies to ordinary business income and not investment income (such as investment capital gain, interest, and dividends), is available to both active and passive investors in pass-through businesses, and is subject to multiple limitations. The limitations apply to all pass-through businesses and it is possible for the deduction to completely phase out, providing no benefit at all.
It is important to note that wages are not eligible for the 20% QBI deduction, and C corporation and S corporation shareholders who extract their residual earnings through payroll bonuses will not realize any benefit from the new deduction. In addition to the C corporation or pass-through analysis, this provides a new planning opportunity for how business owners can pay themselves in a tax-efficient way.
It is important for businesses and investors to understand how their activities and tax profiles impact the owners’ ability to benefit from this new deduction, as it can play an integral role in determining which entity type is the best for any particular business.
Entity Choice – C Corporation or Pass-Through?
Strictly looking at the taxation of business earnings, the lower 21% corporate tax rate appears quite advantageous in comparison to the maximum individual income tax rate of 37% (or 29.6% if a full 20% QBI deduction is available). However, if a business owner intends to extract after-tax cash earnings from a C corporation by making a dividend payment, there will be an additional 20% dividend income tax plus a potential 3.8% net investment income tax on those distributions. If all after-tax earnings are withdrawn by the owners each year, C corporations face a combined tax rate of 39.8% (corporate-level and dividend income tax) compared to 37% or 29.6% (with a full 20% QBI deduction) for pass-through businesses.
The question that drives this analysis then becomes, how much cash do the business owners expect to extract each year?
With a clear plan for future earnings – whether that be to reinvest in the growth of the business, pay down debt, or return cash to the owners – an effective tax rate analysis can be performed to assist in making an educated decision.
For existing businesses, there are a variety of conversion transactions that can qualify for nontaxable treatment for US federal income tax purposes. However, many businesses may not be eligible for nontaxable treatment on a reorganization or change in entity type. The company’s current tax profile should be analyzed to determine the immediate taxability of any conversion transaction.
Additional factors that can impact an entity type analysis include the existence of foreign operations or subsidiaries, potential to attract outside investors, and the unpredictability of today’s American political climate.
Navigating these various factors in order to make an informed entity type decision can be complicated at times, and Wipfli/Macpage is here to help.
This article provides only a brief synopsis of issues related to choice of entity classification for US federal income tax purposes. Consult with your tax adviser regarding your specific situation. For other details about these issues, and other tax issues related to the Tax Cuts and Jobs Act, contact us for more information.