Rethinking Entity Choice in Light of Tax Cuts and Jobs Act

Until the inception of the Tax Cuts and Jobs Act, entity selection by businesses was a fairly easy decision.  In most cases, businesses chose a form of pass-through entity, given the high tax rate of thirty-five percent given to C corporations in the past.  With the new changes brought forth in TCJA, and the lower tax rate of twenty-one percent, change is in the air.  But what are the benefits of considering C corporation status?  Unless you are a very large company, determining if you should change from a pass-through structure to a C corporation will not be an easy one. 

A pass-through entity is a business structure that is used to reduce double taxation.  They are not subject to income tax on the corporate level.  The owners of these entities are taxed on the direct flow-through of their portion of the net income of the business on their personal federal individual Form 1040 return.  Pass-through entities are made up of sole proprietorships, partnerships, S corporations and Limited Liability Companies (LLC). 

In C corporations, double taxation and the higher tax rate were often a determinantal factor.  Double taxation means that the corporate income is taxed at the corporate level and then again when it is distributed to the shareholder as a dividend.  While one strategy is to retain the profits, one then had to be aware of the accumulated earnings tax.

One added benefit that TCJA gave to pass-through entities is the twenty percent deduction under Section 199A on qualified business income.  Generally speaking, qualified business income is ordinary income less ordinary expenses, excluding wages and guaranteed payments earned from the business.  But the bad news is that there are many limitations on the twenty-percent pass-though deduction.  Businesses known as “specified service trades or businesses” where “the principal asset of such trade or business is the reputation or skill of one of more or its employees or owners” are phased out of the deduction, and there are limits based on the size of your payroll, or the amount of property used in the business.  Another hurdle is the definition of trade or business.  When it comes to passive activities such as investment or real estate, the question of whether these qualify as a trade or business has arisen.  At this time, there is no clear guidance.  Additionally, this benefit will sunset in 2025.

With regards to C corporations, the change to the twenty-one percent rate is permanent until a new law changes it.  C corporations also get the benefit of the repeal on Alternative Minimum Tax (AMT).  AMT was originally designed to ensure that a business pay a minimum amount of tax given all of the credits, deductions and loopholes in the codes.  But AMT was not an easy calculation and so its elimination will come as a sigh of relief.  Another change is the simplification of tax method.  Under TCJA, C corporations that have no more than twenty-five million in sales in the past three years can now use the cash method of accounting, even if they have inventory.

So, who may want to consider moving to a C corporation?  If your combined pass-through income and additional taxable income puts your individual tax rate above the twenty percent deduction threshold and passes the phase out threshold, this may be a beneficial move.  If you are a service business, as defined by Section 199A, and are ineligible or phased out of the deduction, then this might be a good choice as well.  Another thought that must be considered is the taxation.  While the tax rate on C corporations is lower, the double taxation still occurs.  And with that, some businesses do not distribute the money to shareholders in the form of taxable distributions, and instead hang on to the funds.  Whereas, with the single taxation of pass-through entities, shareholders receive their distribution funds annually, or do not have to worry about the taxation of a future distribution of withheld funds because it has already been taxed.  Other considerations include: assessing how much changing your entity will save you on your bottom line, the cost associated with making the change, and liability exposure.

If you choose to keep your business as a pass-through entity, the type of pass-through my also come into play.  While originally thought to be an oversight, it has come to be known that there are extensive proposed regulations that confirm the disparity between the Section 199A deduction as it pertains to S corporations, partnerships and sole proprietors. Much of the disparity comes from the use of wages found in the S corporation environment that is not found in the other two pass-through types.  With wages reducing the total net income, the deduction reduces as well.  This further changes with the introduction of property, as the business becomes subject to the wage and property limitations.  If a business operates as an S corporation and is subject to the limitations, the owner(s) will have a W2, and will be able to deduct the twenty percent of the business income but limited to no more than fifty-percent of the W2 income. But given the same income brackets, as a sole proprietor the business would be ineligible for the deduction in its entirety because the threshold would have been reached.

As always, tax choices can be difficult and are very dependent on the specifics or your business.  Reviewing your entity structure, tax benefits, income needs, and determinations of qualifications is strongly encouraged.  It has always been important to consider what type of business entity serves your business best given your field and strategy.  When all relevant factors are considered, switching to a C corporation may not be the best for your business.  Run the numbers with your accountant and see what entity structure works for you, your business, and your goals.  You may be surprised to find that the old standby pass-though entity stays in your good graces.