United States: Tax Planning Strategy Under The New Tax Cuts And Jobs Act

Late in 2017, the Tax Cuts and Jobs Act was passed. It will take effect in 2018.

The Tax Cuts and Jobs Act eliminated or limited a number of different tax preference items. Critically, the Tax Cuts and Jobs Act fundamentally shifted business taxation by making three significant changes:

  • significantly decreasing the corporate income tax rate,
  • creating a new deduction for certain business income flowing from pass-through businesses like partnerships and S-corporations, and
  • lowering individual and trust tax rates.

Taken together, these changes mean that some businesses and their owners may save income taxes over time by converting from pass-through status (LLCs taxed as tax partnerships and S-corporations) to C-corporation status. Which businesses would benefit from a conversion is not clear or intuitive and requires significant analysis, based on a number of financial and tax factors. A business should also consider the risk that the new individual or corporate rates may be further adjusted by Congress in the future as well as the ramifications of a conversion for any future business exit, business succession planning, new capital investments, or equity compensation plans.

Decrease in Corporate Income Tax Rate to 21%

The potential for savings comes from a dramatically lower corporate income tax rate – beginning in 2018, C-corporations will pay a flat rate of 21% (down from 35%). In addition, the corporate alternative minimum tax has been repealed. This new rate will also apply to personal service corporations.

Individuals who receive dividends paid from a C-corporation are still subject to the 20% preferred dividend rate (the second level of the corporate "double taxation" regime). But, the dividend tax is only incurred when the corporation chooses to pay dividends to shareholders. Businesses that opt to retain earnings for growth are subject only to the 21% income tax rate while they may defer the tax on dividends into the future. C-corporations also gain better treatment of income earned overseas.

Income Tax Relief to (Some) Pass-Through Owners

Tax relief was extended to owners of "pass-through" entities (S-corporations and partnerships) as well.

First, income allocated from a pass-through entity will be subject to lower individual income tax rates. The top individual rate decreased from 39.6% to 37%.

Second, the Act provides a new deduction for "qualified business income" (QBI) most often received from a pass-through entity. QBI generally includes the net amount of domestic ordinary income generated from a taxpayer's business during the year. Investment income (e.g., interest, dividends, and capital gains) do not qualify. A partner or shareholder is eligible for a deduction of up to 20% of QBI reported on his or her individual return.

However, the QBI deduction is limited in a number of ways:

  • For certain specified businesses (like accounting and legal practices, medical, consulting, financial services, and certain other service-based businesses), the deduction is only available if the individual recipient's overall taxable income does not exceed $157,500 ($315,000 married filed jointly), at which point the deduction phases out until no longer allowed.
  • For all other businesses, the deduction is subject to a wage and capital limitation if the recipient's overall taxable income exceeds $157,500 ($315,000 married filing jointly).

    • A taxpayer's deduction is limited to the greater of:

      • 50% of the taxpayer's allocable share of W-2 wages paid by the business or
      • 25% of the taxpayer's allocable share of W-2 wages plus 2.5% of the taxpayer's allocable share of the unadjusted basis of certain assets held by the business.
  • For all taxpayers, the deduction is limited to 20% of the amount taxable income exceeds net capital gain.

    (Note: this article does not include a number of special provisions for other types of income).

The extent to which the income from a pass-through business (and its owners) qualifies for the QBI deduction is very important in determining whether it is advantageous to explore a conversion to C-corporation status. The QBI deduction is also set to expire after December 31, 2025.

In some circumstances, converting to a C-corporation may also add an additional benefit of excluding gain on the sale of stock if the stock qualifies as Section 1202 Small Business Stock (the reach of this provision is fairly limited).

Possible Disadvantages of Converting to C-corporation Status

Importantly, converting to C-corporation status has some significant disadvantages, which may not be apparent from simply re-calculating the income tax due using the new income tax rules.

  • Generally, converting back to pass-through status may be cost-prohibitive or otherwise impractical when and if the tax laws are subsequently changed or the circumstances of the business or its owners change. In the event of a subsequent change in law, a business may not be able to revert back easily or for a considerable period of time.
  • C-corporations are not able to pass business losses to their owners and revised net operating loss rules may make retaining losses less attractive than before.
  • C-corporations may be subject to more adverse state income tax consequences (e.g., a 5.5% corporate tax rate in Florida). On the other hand, some activities, like manufacturing, are advantaged under state income tax statutes.
  • Tax distributions paid by pass-through entities are often useful in estate planning transactions (tax distributions are used to rapidly retire promissory notes from installment sales to grantor trusts—a popular estate planning technique).
  • The basis of partnership property may be adjusted upwards because of the step up in basis due to a partner's death (this is not available for C-corporation property).
  • Sellers of pass-through entities may realize higher purchase prices at the sale of the business because of the ability to sell "stepped up" basis to a buyer at little or incremental cost to the sellers. The impact of this benefit differs by buyer and by industry.

Situations Where Businesses May Benefit

In the past, it has been the case that businesses are generally better off as pass-throughs (either S-corporations or partnerships). With the new rules, some pass-throughs may be better off converting to a C-corporation status if:

  • The QBI deduction is not applicable or limited based on owners' income, the underlying business, or the other limitations;
  • The business does not plan to make dividends or distributions (and will reinvest earnings into the business) and the business generates significant taxable income;
  • The owners don't intend to sell the business in the foreseeable future or there is limited value to a basis step-up from the sale of assets;
  • The business generates significant profits overseas; and/or
  • The owners do not expect the provisions of the Tax Cuts and Jobs Act to be materially repealed or modified in the coming years.

Because of the long-term implications of the decision (not all of which are obvious or even addressed in this overview), clients are generally taking a full look at the benefits and risks before making a decision to convert to C-corporation status.

In many cases, the decision to be a C-corporation can be made retro-active to January 1, 2018 as late as March 15, 2018.

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.

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