Impact of Tax Reform on Choice of Entity after the Tax Cuts and Jobs Act
Last November, we examined the potential impact of Tax Reform on Choice of Entity. Since the Tax Cuts and Jobs Act was signed into law on December 22, 2017, taxpayers have been working through the changes to try and understand the impact to themselves and their businesses. The Act impacted many areas of the tax law and, as a result, has caused many taxpayers to reconsider their current entity structure.
Changes Impacting Choice of Entity
- The C Corporation tax rates were reduced from a top rate of 35% to a flat rate of 21%. In addition, the corporate alternative minimum tax was repealed. The change is effective beginning January 1, 2018 and is permanent.
- The individual tax rates were reduced from a top rate of 39.6% to a top rate of 37%. The changes to the individual rates sunset after December 31, 2025.
- Pass-through entities are allowed a 20% deduction on qualified business income effectively connected to a U.S. trade or business. The deduction reduces the top tax rate on qualifying income to 29.6%. Services as an employee or specified service income (to the extent above threshold below) is not eligible for the deduction. If taxable income exceeds $315,000 for a joint return ($157,500 for single taxpayers) limitations phase-in over the next $100,000 of taxable income ($50,000 for single taxpayers) limiting the deduction to the greater of i) 50% of wages paid by the business or ii) 25% of wages plus 2.5% of the unadjusted basis of certain depreciable property.
- C corporations operating through certain foreign corporations are allowed a 100% dividend received deduction on profits earned through the foreign corporation. In addition, C corporations are allowed preferential tax treatment on income taxed under the new Global Intangible Low Taxed Income Inclusion as well as a preferential rate on foreign derived intangible income.
Background on Choice of Entity
Generally speaking, businesses have the choice to be taxed as a C Corporation, where the entity pays the tax liability, or a pass-through business where the owners of the business are subject to tax on their distributive share of the income. Owners of pass-through entities pay tax when the income is earned but do not pay tax again when the profits are distributed to the owners. This single level of tax is the primary reason businesses choose to be organized as a pass-through entity. In contrast, profits from C Corporations are “double taxed” as dividend income when paid to the owners.
The easiest way to demonstrate the differences is to walk through an example that compares a pass-through entity with a C corporation on earned income that is retained, and then contrast that to earned income that is distributed out to the owners.
The following calculation compares an S corporation to a C corporation where the income is fully taxed in Minnesota. The calculation assumes the owners are in the top tax brackets and active in the business.
What the example helps illustrate is that C corporations can result in less tax on retained profits but pass-through entities can result in less tax on profits distributed to the owners. So what is the right answer?
The choice of entity analysis takes into account the rates as illustrated above but also considers a number of factors, including:
- Current and expected financial projections of the business
- Need of the business to retain profit and expected return on retained profits
- Owners exit strategy and timeline
- State activity and residency of the owners
- Ability to utilize IRC 1202 exclusion available to eligible C Corporations
- Current and expected tax brackets of business owners
- International operations and foreign tax related to business operations
- Expectations on future tax environment and potential sunset of 20% pass-through deduction and individual tax rates
As the above list of considerations illustrates, choosing the right entity type can be a complicated analysis that needs to consider a wide range of issues.
The Tax Cuts and Jobs Act has provided the incentive for many taxpayers to reconsider their current structure due to the potential benefits. If you have any questions regarding how the Act may impact you or your business, please contact John Kammerer, Partner, and Business Tax Service Area Leader today.