Choosing a business entity — whether a C corporation, S corporation, partnership, limited liability company, or sole proprietorship — is one of the first, and most important choices you will make for your business. The Tax Cuts and Jobs Act (TCJA) of 2017 made the most sweeping changes to the Tax Code in decades, and may have changed what most business people thought they knew about how to configure their companies for maximum tax advantage. Let's explore the new corporate tax rate changes and what they mean for your choice of business entity.
At first glance, it looks as if the TCJA has made the C corporation a more desirable option, viewed through the lens of income tax obligations. Under Chapter C of the Internal Revenue Code (which gives this business entity its name), the profits of a C corporation are taxed separately from its owners. An S corporation, in contrast, passes profits on to shareholders, and those profits are taxed on their personal income tax returns.
Under the TCJA, C corporations, including personal service corporations, are taxed at a flat federal income tax rate of 21 percent. (This is a reduction from the former top rate of 35%.) Compare this to the highest federal income tax bracket for pass-through income, which is 37 percent. Granted, this top rate can be brought down to as low as 29.6 percent using the TCJA's 20 percent deduction for qualified business income (QBI). This assumes, of course, that the business income that passes through to the taxpayer qualifies for the maximum deduction.
S corporation owners who are employed by their companies are required to report as compensation income the lesser amount of a) cash received from the business or b) "reasonable compensation."Distributions classified as wages are ineligible for the 20 percent deduction for QBI referenced above.
The lower corporate tax rates for C corporations are the upside; the downside is distributions being taxed as dividends. Qualified dividends are taxed to a corporate shareholder at a top federal income tax rate of 23.8 percent. This takes into account net investment income tax. The taxation of corporate profits, even at the new lower rate, and the taxation of distributions as dividends at both the federal and state level considerably reduces the appeal of C corporations.
In a nutshell, a C corporation can yield good outcomes as far as income tax is concerned, but only if it reinvests, rather than distributes, most of its income. For business owners who intend to do just that, a C corporation might be a good choice of business entity. However, it is important to remember that unlike with an S corporation, earnings that are reinvested into the company do not add to the corporation's stock basis. If one anticipates selling the corporation at some point, this should be taken into account.
As pass-through entities, S corporations and partnerships are not subject to the double income taxation that impacts C corporations, and the ability of owners to build up their tax basis in the entity has traditionally made pass-through entities an attractive choice. The reduction in the tax rate for C corporations may cause some business owners to reconsider their choice of entity.
The TCJA has brought about many changes, not least of which is the elimination of the corporate Alternative Minimum Tax (AMT). For individuals, the AMT exemption is greatly increased under the TCJA; this means that a much smaller percentage of owners of pass-through businesses will be subject to the AMT.
For businesses in areas with high state and local taxes, the ability to deduct those taxes on federal income tax is of interest. Corporations are able to fully deduct local and state taxes. In contrast, business owners reporting pass-through income from their business entity may only deduct up to $10,000 of local and state taxes.
Corporations can, under the TCJA, carry forward net operating losses (NOLs) indefinitely (but note that the ability to carry NOLs back for two years is no longer allowed). Owners of pass-through business entities such as S corporations may only offset up to $500,000 of business losses. Excess business losses must be carried forward.
Income tax considerations play a large role in choice of business entity, but they are far from the only considerations. Other factors to take into account include flexibility in raising capital, exposure to personal liability (for sole proprietorships or partnerships), ease of transferring ownership, and ease of incorporation.
If you have already chosen a business entity, but are considering a change in light of the new tax laws, remember that it is essential to consider the broad picture with an attorney who can explain the legal and tax implications of your options. Each situation is unique, and your choice will depend not only on the law, but on your circumstances and goals, including whether you are seeking to pass your business on to the next generation of your family.
If you have questions about corporate tax rate changes and choice of business entity under the TCJA, we invite you to contact our law office.
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