Choice of Entity Becomes Even More Important After Tax Reform
One of the most significant effects of the Tax Cuts and Jobs Act (TCJA), passed at the end of 2017, is the impact it had on all forms of business entities. The dramatic reduction in the income tax rates for C corporations is complemented by the decreased top individual rate and the new pass-through business income deduction under Section 199A. These are all tremendous benefits to businesses. While entity choice isn’t just about tax rates, the rate changes are drastic enough to prompt many pass-through business owners to consider a conversion to a C corporation, as well as existing C corporation owners to examine all alternatives.
The changes made by the TCJA affecting this choice are historic. C corporation tax rates have been reduced from 35% to 21%, which is a rate not seen since before the Second World War, nearly 80 years ago. In contrast the top tax rate on individuals, via pass-through entities, has been reduced from approximately 42% (after phase-outs) to 37%, and “passive” owners continue to tack-on another 3.8% net investment income, a tax not levied on C corporations. Qualifying pass-through owners can receive a new deduction of up to 20% on their business income, potentially lowering their effective Federal tax rate further, to 29.6%.
The analysis as to what type of entity to adopt for your company is not just one a new enterprise should engage in, but rather all companies should examine if a change of entity type would benefit them going forward. All pass-through entities, including partnerships, sole-proprietors and S corporations, should evaluate their ongoing choice of entity as a result of tax reform and the newly reduced corporate tax rate of 21%. In addition, another benefit of being a C Corporation in 2019 is the elimination of the AMT for C corporations. For many companies this is a massive tax savings that goes beyond tax rates by purging a second level of taxes that had crippled certain industries and companies for decades.
Points to Consider
- The new corporate tax rate of 21% is significantly lower than the individual tax rates, now having a maximum rate ranging from 29.6% to 37%. The increase from a C corporation rate to an S corporation is at least 40%. Because of this difference, a C corporation entity should have more after-tax cash available to re-invest, creating incrementally greater value to its owners as compared to a pass-through entity.
- The effective tax rate differential between corporate (including the double taxation effect) and pass-through entities has been significantly reduced. This has created an environment where even with a double level of taxation, a C corporation structure may generate greater after-tax cash value to its owners as compared to a pass-through entity. (See below under Key Factors.)
What Are the Key Factors to Consider?
- Taxable Income
Inherent in considerations to structure companies in a tax efficient manner is an expectation that the company plans to generate current and future income that will be subject to taxation. If the entity is a start-up or anticipates losses for the next several years, then a pass-through entity may be a better choice.
- Section 199A
The Section 199A Deduction may reduce a pass-through owner’s maximum individual effective tax rate from 37% to 29.6%. It is critical to begin evaluating the extent the pass-through owner will be eligible for this deduction as part of the Choice of Entity analysis. The deduction is not assured, and many pass-throughs will fail to avail themselves of this benefit, making the choice of a C corporation even more advantageous.
- Future Plans: Reinvest or Distribute
The ability to generate incremental revenue and value on reinvested cash favors a corporate entity, due to the lower initial tax liability. It’s important to evaluate whether a company plans on reinvesting or distributing their after-tax cash, as this will significantly impact the overall effective tax rates and bring the dreaded double level of taxation into play. Likewise, if the owners intend to sell the company in the near future, that will impact the analysis.
- Domestic Tax Reform
Impact of other tax reform provisions on the company’s overall income tax liability may increase or decrease the benefits of an entity change. For instance, tax reform changes have affected rules surrounding the amount and timing of income recognition. A company may benefit from these changes via selecting more advantageous accounting methods following a change in entity.
The decision to adopt a specific type of business entity, or to change your entity status, is an important and complex one. Proper planning can save the company vast amount of taxes and increase its value. This should only be done after a careful and well-informed examination of the possibilities is undertaken.
Dannible and McKee, LLP has extensive experience and expertise in this area, and we have the personnel and knowledge to assist you in making the right choice.