Business Entity Choice – After TCJA
Which entity a business should use – sole proprietorship, partnership, S corporation or C corporation, has, in the past, been a decision that requires weighing a large number of factors. The changes made by the Tax Cuts and Jobs Act of 2017 (TCJA) most notably, the reduction in the corporate tax rate and the introduction of the qualified business income (QBI) deduction, now change those factors.
Note that the discussion below is geared to newly forming businesses. That is, it does not consider conversion of the entity form of an existing business to another entity form. Such a conversion has additional complications, particularly where the conversion is from a corporation to a pass-through entity.
Here are some of the significant factors to consider when choosing whether to be a C corporation or a pass-through entity after the TCJA:
Tax rates. The corporate tax rate is a flat 21%, while pass-through entity income that flows through to an individual partner is subject to a tax at a maximum 37% rate. But, then things get more complicated.
Pass-through entities may qualify for the 20% QBI deduction, which creates a maximum effective rate of 29.6%. But, the QBI deduction is not allowed for most service businesses whose taxable income is $415,000 or more ($207,500 or more if not married filing jointly), is only partially allowed for most service businesses whose taxable income is $315,000 or more ($157,500 or more if not married filing jointly), and is subject to significant limitations for other businesses whose taxable income exceeds the above dollar amounts. Conversely, many small business owners are not in the top 37% bracket.
Two levels of taxation of corporation income: one at the corporate level on corporate earnings and one at the shareholder level, e.g., on dividends. Dividends are generally taxed at the qualified dividend rate, which is a maximum of 20%. However, in many cases such dividends are also subject to the 3.8% net investment income tax. So, where a corporation pays out its after-tax earnings as dividends, the combined federal corporate/individual rate on corporate income can be as high as 39.8%, i.e., 21% + [(20% + 3.8%) x (100% – 21%)] And, generally, dividends do not receive any kind of preferential rate at the state and local level.
Corporations are able to and want to retain profits in the business rather than pay dividends. In that case, the tax rate temporarily stays at the 21% imposed on the corporation. New business owners who believe that they will be in that situation should consider various factors:
• Corporation owners and their heirs can avoid all or some of the tax at the individual level if the owner holds onto the stock until he passes away, at which time the stock will receive a step-up in basis to its fair market value.
• If the business owner sells all of the stock of his corporation, the retained profits will not be directly taxed. Rather, the business owner will be taxed only on the difference between his basis in the stock and the selling price of the stock.
• Code Sec. 1202 provides a 100% exclusion for gain on the sale or exchange of qualified small business stock that a C corporation issued to a noncorporate taxpayer (or was issued to a donor or decedent who transferred the stock to the taxpayer) if certain conditions are met. Among those conditions are: the corporation was never an S corporation, the stock was held for more than five years, and at least 80% of the corporation’s assets are used in certain active businesses. The professions are not one of those types of active business.
• C corporations can provide money to their owners via, for example, salary, benefits and/or loans, and thus can avoid, or minimize, the paying of dividends. Note, however, that loans must meet certain formalities, and salary and benefits, etc. must be reasonable in amount, in order that they be respected for tax purposes.
• A C Corporation that does not distribute its profits can be subject to the accumulated earnings tax and/or the personal holding company tax.
Other factors that should be considered when choosing a business entity:
• Often, even successful businesses have losses in their early years. While an owner of a pass-through entity can offset his other income with those losses, a C Corporation owner cannot do that.
• Partners in partnerships, and owners of more than 2% of the stock or 2% of the voting power of S corporations, are denied certain tax-free benefits that are available to employee-owners of C corporations. For example, they are not entitled to:
(1) the exclusion from income of amounts received from an accident and health plan,
(2) the exclusion from income of amounts paid by an employer to an accident and health plan,
(3) the exclusion of the cost of up to $50,000 of group-term life insurance on an employee’s life, and
(4) the exclusion from income of meals and lodging furnished for the convenience of the employer.
In summary, entrepreneurs in start-ups should consider, among other things:
1) what tax bracket they would be in if the business was a pass-through;
2) how much of a QBI deduction, if any, they would be entitled to if the business was a pass-through;
3) whether they are able to and would want to retain profits in a C Corporation;
4) if they do retain profits in a C Corporation, how and when they project they will eventually get the profits out of the Corporation, sell the Corporation, etc.;
5) whether they anticipate the business will have losses in its early years; and
6) the amount of tax they would save with respect to employee benefits they intend to provide for themselves by being a C corporation as opposed to being a pass-through.
7) An additional factor to consider: the TCJA was passed without bipartisan support. One should consider the possibility that the TCJA changes, particularly the significant reduction in the corporate tax rate, could be adjusted if Democrats gain control of Congress and/or the White House.