Tax Reform’s Impact on Choice of Entity
The recent passing of the Tax Cuts & Jobs Act, with the dramatic reduction in the corporate tax rates, warrants a close analysis of the proper business entity structure for every company to ensure that income generated receives the most advantageous tax treatment. Since construction businesses tend to be closely held and therefore organized as flow-through entities, it is particularly important that these companies to evaluate whether there would be tax benefits in converting to a C corporation.
In most cases, revoking the company’s Subchapter S election and operating as a C corporation would not be beneficial for the company, despite the reduced federal income tax rate of 21% applicable to C corporation income. This is primarily due to the double taxation that continues to occur for C corporations, even under the recently enacted tax legislation.
S Corporation Structure
As an S corporation, the income generated by the company, after payment of “reasonable compensation” to the shareholder-employees, is passed-through to the individual shareholders and then taxed at their effective individual federal and state income tax rates. To the extent available in cash, these corporate earnings may then be distributed to the individual shareholders. Assuming the shareholders have adequate basis in their S corporation shares, these distributions are tax-free to the recipients.
Included in the 2017 Tax Cuts and Jobs Act, a new 20% Qualified Business Income Deduction (QBID) is available on most pass-through income received by shareholders in non-service-based S corporations. While the regulations related to the 20% QBID have yet to be finalized, it is currently believed that any contractor, architect or engineer incorporated as an S corporation would be eligible for this deduction.
The earnings paid out to the shareholder-employees of the company as wages are subject to both ordinary income taxes and to self-employment taxes (FICA) at the individual level. It is important to note that while the pass-through earnings of an S corporation are not subject to self-employment taxes, the compensation paid to the shareholders performing substantial services within the entity must be reasonable (i.e. not set artificially low to avoid the imposition of FICA taxes). The determination of reasonable compensation is based on a “facts and circumstances” test, which often looks to comparable salaries for the performance of similar services within the specific industry.
Based on the above rules, an S corporation shareholder would pay a maximum marginal rate of 29.6% (37% federal rate less 20% QBID) on S corporation earnings after reasonable compensation.
C Corporation Structure
For entities organized as a C corporation, the new federal tax rate of 21% will apply to the taxable income generated by, and retained in, the entity. Again, shareholders that are providing substantial services to the company would need to receive a reasonable salary. The income not paid out as wages that are distributed to the shareholders would then be taxed as qualified dividends, subject to a 15% or 20% tax rate, and possibly the 3.8% tax on net investment income. As a result, the tax paid on earnings would be “double-taxed,” resulting in a maximum federal rate of 44.8% (21% + 20% + 3.8%).
For many construction businesses that commonly distribute the majority of current earnings to shareholders, taxation as a C corporation would not be advantageous as it would result in additional tax on the earnings generated.
It is important to note that an additional benefit of operating as an S corporation is the ability to increase each shareholder’s basis in their stock, as pass-through income increases basis. This increase in basis is offset by shareholder distributions. However, the retention of some income in the company, whether for growth, fixed asset additions or debt payment, typically causes a shareholder’s basis to increase over time. The same is not true in the case of a C corporation, where a shareholder’s basis remains fixed at the amount paid to initially acquire their shares. This is yet another tax benefit of operating in the S corporation structure because basis ultimately reduces the capital gains to be recognized on the sale of shares in the company.
Alternatively, earnings accumulated within a C corporation will only be subject to the 21% corporate tax rate. The 20% long-term capital gains tax on dividends and 3.8% net investment income tax would not be assessed until the accumulated earnings were eventually distributed as dividends or until the shareholder sold their shares of the corporation.
The most beneficial entity structure will depend on your short-term, mid-term and long-term plans for distributions (dividends), stock ownership and business growth. No single solution will work for every situation. If you reasonably expect to maintain a significant portion of earnings within the corporation for a long period of time, the 21% corporate tax rate would be more advantageous than the blended 29.6% tax rate for S corporation shareholders qualifying for the QBID deduction. For shareholders of S corporations that do not qualify for the 20% QBID deduction, the maximum federal tax rate is 37%, a differential of 16% compared to a C corporation that will accumulate earnings instead of making distributions. Not discussed in this article, but equally important, is the impact of entity selection on state taxation.
Regardless of your current entity structure, it is important that you consult with a tax professional to determine the impact of the new tax law changes on your entity structure. The facts and circumstances of each business are unique and will impact the determination of which entity structure best suits current operations and practices.