The recent corporate tax cut has many pass-through business owners rethinking their choice of entity. The Tax Cuts and Jobs Act (TCJA) slashed the federal corporate income tax rate to a flat rate of 21% from a top rate of 35% and eliminated the corporate alternative minimum tax (AMT). Meanwhile, owners of pass-through entities — partnerships, S corporations and LLCs — are taxed on their shares of business income at individual rates as high as 37% (down from 39.6%).
At first blush, it seems that the corporate form offers a substantial tax advantage. Why pay tax at a 37% rate when you can enjoy a 21% tax rate on the same income? Unfortunately, it is not that simple. Let's review some of the factors to consider in determining whether organizing your business as a C corporation would reduce your overall tax burden.
What's your true pass-through rate?
Although the top individual income tax rate is 37%, a pass-through owner's true tax rate may be higher or lower, depending on his or her circumstances. For example, an owner who does not materially participate in the business may be subject to an additional 3.8% net investment income tax (NIIT).
Also, the TCJA created a new pass-through deduction, which allows owners of certain pass-through entities to deduct up to 20% of their share of qualified business income (QBI) through 2025. The deduction is subject to a variety of limitations and exclusions, depending on the nature of the business and the income levels of its owners. But, assuming that a pass-through owner qualifies for the full deduction and that all of his or her income from the business is QBI, the owner's actual pass-through rate will be approximately 29.6%.
What about double taxation?
Even with the benefit of the pass-through deduction, a pass-through entity's effective tax rate is higher than the 21% corporate tax rate. But, it is also necessary to consider whether a C corporation's effective tax rate is increased by double taxation. If a C corporation distributes its earnings to its owners in the form of dividends, that income is taxed twice — once at the corporate level at the 21% rate and again at the individual shareholder level at rates as high as 23.8% (the 20% qualified dividend rate for high-income taxpayers plus the 3.8% NIIT). Double taxation results in an effective tax rate in excess of the top 37% bracket for individuals.
Some C corporations can defer double taxation by paying out earnings to owners in the form of salaries and benefits or by reinvesting earnings in the business. Note, however, that the accumulated earnings tax (AET) and the tax on personal holding companies (PHCs) may erase the benefits of retaining corporate earnings under certain circumstances.
What's your exit strategy?
Even if a business is able to operate as a C corporation without distributing its earnings, doing so merely defers double taxation rather than avoiding it altogether. If the business assets are sold, the sale proceeds will be taxed at the corporate level and then again when distributed to the shareholders. If the owners contemplate a sale of the business assets in the near term, a pass-through entity may be preferable. If the eventual sale of stock is anticipated, a C corporation may be preferable.
What if the TCJA is repealed or modified?
Although the 21% corporate tax rate is characterized as a permanent change, that just means that the rate is not scheduled to expire or sunset in 2026, like many of the TCJA's individual income tax provisions. However, that does not mean Congress will not repeal or modify some or all of the TCJA's corporate provisions down the road.
It is important to consider the possibility that the corporate tax rate will be increased in the future. If you organize your business as a C corporation or convert an existing pass-through entity into a C corporation and the advantages of C corporation status are eliminated, converting back to pass-through status may prove to be cost prohibitive.
Will you benefit?
Determining whether your business would benefit by operating as a C corporation is a complex process that depends on a variety of tax and nontax factors (see the Sidebar). Generally speaking, C corporation status may be appropriate if 1) your business does not plan to distribute earnings; 2) retaining earnings does not raise AET or PHC tax concerns; 3) your owners are ineligible for the pass-through deduction; 4) you do not intend to sell the business in the coming years; and 5) you do not expect the TCJA to be repealed or substantially modified in the foreseeable future.
Sidebar: Other considerations
The main article discusses some, but by no means all, of the factors you should consider in determining the ideal structure for your business. Here are some other factors to consider:
- Pass-through entities offer greater flexibility to allocate profit and loss according to criteria other than ownership interests;
- Unlike C corporations, pass-through entities are able to pass business losses to their owners;
- Owners of pass-through entities may be able to command a higher purchase price because the buyer obtains a stepped-up basis in the company's assets;
- For certain types of businesses, such as real estate firms, a partnership or limited liability company is the entity of choice for various tax and non-tax reasons; and
- Pass-through entities may be better suited for certain estate planning techniques.
Finally, do not overlook the impact of state taxes on your choice of entity.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.