The Tax Cuts and Jobs Act (TCJA), signed by President Trump in Dec. 2017, has significant implications for how businesses will assess the choice of entity. Prior to reform, partnerships were a very common choice of entity, but with the new provisions in TCJA, the C corporation has become an appealing option once again (but with some caveats).
The assessment by the National Law Reviewprovides details on these signficant developments in choice of entity. In general it makes a helpful point: the entity choice will continue to involve a number of considerations, such as the makeup of the investor base, capitalization structure, borrowing requirements, likelihood of distributing earnings, state tax environment, compensation and benefit considerations, participation of owners in the business, presence of foreign operations, and sale or exit strategies.
Although the decision is always complex and never exactly cut and dry, the NLR’s report looks at several major impacts on choice of entity, including the following highlights:
- C corporations are now subject to a flat corporate income tax rate of 21%, down from a maximum rate of 35% under prior law. The corporate alternative minimum tax has also been repealed, which simplifies tax reporting for many corporations. Although the state income tax deduction has been severely limited for individuals as discussed below, the deduction has been preserved for corporations. Dividends paid by domestic C corporations are still subject to the maximum 20% qualified dividend rate that applied under prior law.
- Following tax reform, C corporations are now subject to a maximum effective federal tax rate of 39.8%, assuming that all net income is distributed to shareholders and that the 3.8% net investment income tax applies to all dividends paid.
Business Law Today notes that C corporations have become much more attractive from the standpoint of annual income taxes than S corporations, partnerships, or sole proprietorships (collectively, pass-throughs):
- As noted above, C corporations now have a flat, 21-percent federal income tax rate. Even personal service corporations use the new low rate. This contrasts with the top federal income-tax bracket of 37 percent for pass-through income, which may be reduced to 29.6 percent by way of a 20-percent deduction for qualified business income—if and to the extent that one’s pass-through qualifies for the deduction.
- Partners and sole proprietors in lower income-tax brackets face 15.3-percent self-employment tax, and those in the highest brackets may pay 3.8-percent self-employment tax or net investment income tax.
- S corporation owners who work in the business must report compensation income to the extent of the lesser of cash they receive or “reasonable compensation,” and in 2017 the IRS explained to its agents how to keep taxpayers out of tax court when the IRS reclassifies distributions as compensation. Any amounts classified as wages are not eligible for the 20-percent deduction.
There are caveats to the attractiveness of the C corporation. Although C corporation tax rates are lower, this is tempered by the taxation of distributions as dividends. A shareholder in the top bracket pays 23.8-percent federal income tax on qualified dividends, considering net investment income tax. Add state income tax, and the double taxation involved in declaring dividends each year can make C corporations unattractive, as noted by Business Law Today.
This only touches the tip of the iceberg, but the bottom-line from Business Law Today is this: a C corporation will likely produce superior annual income tax results, but only if the company reinvests a large portion of its income.
These points provide only a brief survey of a vast and complicated topic. The reader is encouraged to study the reports linked above in detail. In addition, this article does not constitute advice of any sort. It is imperative that you consult with your own legal and tax professionals before making any move as many of the complicated factors mentioned in the topics above can vary on a case-by-case basis for businesses.
Have a question? Contact Jim Marshall.