Entity Choice Under The New Tax Law

By: Randall A. Denha, J.D., LL.M.

Tax reform has once again taken center stage. The Tax Cuts and Jobs Act (TCJA), signed by President Trump in Dec. 2017, has significant implications for how businesses will assess the choice of entity. Prior to reform, partnerships were a very common choice of entity, but with the new provisions in TCJA, the C corporation has become an appealing option once again. The Act’s headliner change is the flat 21 percent tax rate for ordinary corporations. This new rate is a substantial reduction from the previous top corporate rate of 35 percent and, consequently, many businesses not currently classified as C corporations for tax purposes are considering whether to convert to a C corporation to take advantage of this new rate. Lets look at the tax effects of different choices of entity and also look at the non-tax reasons why some entity choices will be more advantageous.

C-Corps and Flow Through Entities.

C corporations have become much more attractive from the standpoint of annual income taxes than S corporations, partnerships, or sole proprietorships (collectively, “flow-through entities”):

• As noted above, C corporations now have a flat, 21-percent federal income tax rate. Even personal service corporations use the new low rate. This contrasts with the top federal income-tax bracket of 37 percent for pass-through income, which may be reduced to 29.6 percent by way of a 20-percent deduction for qualified business income—if and to the extent that one’s pass-through qualifies for the deduction.
• Partners and sole proprietors in lower income-tax brackets face 15.3-percent self-employment tax, and those in the highest brackets may pay 3.8-percent self-employment tax or net investment income tax.
• S corporation owners who work in the business must report compensation income to the extent of the lesser of cash they receive or “reasonable compensation.” Any amounts classified as wages are not eligible for the 20-percent deduction.

There are caveats to the attractiveness of the C corporation. Although C corporation tax rates are lower, this is tempered by the taxation of distributions as dividends. A shareholder in the top bracket pays 23.8-percent federal income tax on qualified dividends, considering net investment income tax. Add state income tax, and the double taxation involved in declaring dividends each year can make C corporations unattractive.

One of the most significant outcomes of the Tax Cuts and Jobs Act (TCJA) is the difference between the new tax rates for C corporations and for flow-through business income. While entity choice isn’t just about tax rates, the rate changes are drastic enough to prompt many flow-through business owners to consider a conversion to a C corporation.

The changes made in the TCJA affecting this choice are significant. C corporation tax rates have been reduced from 35% to 21%, while the top tax rate on individuals has only been reduced from 39.6% to 37%, and “passive” owners tack-on another 3.8% net investment income tax not levied on C corporations. Qualifying flow-through entity (FTE) owners can use a deduction of up to 20% of their FTE income, potentially lowering their effective federal tax rate on FTE income to 29.6%. But the reduced rate for individuals and the 20% pass-through deduction are both scheduled to expire at the end of 2025, while the C corporation rate cut is permanent.

The 21% rate on business income for a C corporation is a compelling reason to consider an entity change. That level of cash flow from tax savings each year is a very powerful tool to enable a business to stay competitive with other C corporations in its industry and to fund future growth.

Qualified Business Income (“QBI”).

When the TCJA was passed, Congress felt that some benefit needed to be provided for flow-through entities to, in a sense, offset the benefit that was provided corporations with the reduction in the tax rate. Therefore, Congress passed a new 20 percent deduction for qualified business income (the “20 percent QBI deduction”) earned by flow-through businesses to reduce the tax liabilities of the owners. Generally though, provided that certain tests are met, the 20 percent QBI deduction can lower the effective tax rate paid by the active owners of flow-through businesses to a low of 29.6 percent for certain business income (assuming the highest federal income tax rates and depending on whether the 3.8 percent tax on net investment income applies). Since these levels of taxation would often be lower than the effective rate of 39.8 percent paid on this same business income by a C corporation and its shareholders, this new 20 percent QBI deduction may encourage eligible businesses to stay in the flow-through form, although the deduction is currently slated to “sunset” after 2025.

Note: Calculations assume the highest federal tax rates apply and all of a corporation’s after-tax earnings are distributed to shareholders by way of taxable dividends subject to the 3.8 percent net investment income tax. State income taxes are ignored.

Operations.

How can your choice of entity affect the operations of a business? Generally, contributions of capital into flow-through entities and C corporations (provided certain “control” requirements are met) are tax-free to both the contributor and the business entity. However, distributions of cash and property are treated differently: Flow-through entity distributions can be tax-free, while C corporation distributions are usually taxable transactions. For instance, a distribution of appreciated property from a C corporation triggers two layers of taxation—one at the corporate level, and another at the recipient shareholder level. But a distribution of appreciated property from a partnership can be tax-free.

Accordingly, businesses that routinely distribute earnings may choose the flow-through form over a C corporation to avoid the double layer of tax, especially if the income from the business will be taxed at a lower rate due to the new 20 percent QBI deduction. Alternatively, certain capital intensive businesses that do not distribute their earnings, but reinvest such earnings, may find the C corporation form advantageous because those earnings are only subject to the 21 percent rate.

There is always the chance that future tax legislation could change things again. For instance, if the corporate tax rate rises, businesses that previously chose a C corporation form may not be able to convert to a flow-through form without triggering material tax consequences.

Another consideration not touched upon in this insight is state and local income taxation. Operating in a state with a relatively high corporate tax rate could encourage a business entity to adopt the flow-through form.

Change in Ownership

Businesses with frequent changes in ownership may favor the flow-through form. A purchaser of an interest in a LLC classified as a partnership can receive a basis step-up in the purchaser’s share of the LLC’s assets (provided a section 754 election is properly made), entitling the purchaser to potentially higher depreciation and amortization deductions. This step-up in basis can also occur upon the death of a flow through owner when the ownership interest transfers to an estate and heirs. In contrast, the purchaser of stock in a C corporation is not entitled to the same benefits. This is also true for the purchase of stock in an S corporation. However, a purchaser may still prefer the S corporation stock over C corporation stock because future gains from operations or sales of property will generate only a single layer of tax.

On the other hand, a business with a relatively static ownership structure may be indifferent to possible basis step-ups. These types of businesses may prefer the C corporation form.

Selling The Business

In addition to taking less liability risk, a purchaser of a business may pay a premium to purchase business assets over equity because the purchase of assets generates cost recovery tax benefits like depreciation and amortization. Generally, an asset sale can be accomplished more tax efficiently when the assets are held by a flow-through entity because the gain is only subject to a single layer of tax. For a business entity classified as a partnership, the sellers can sell their partnership interest and pay tax at capital gains rates, subject to other rules, while the purchaser can take a cost basis in the underlying partnership assets via a section 754 step-up election discussed above.

One other differentiator that may favor classification as a C corporation over a flow-through entity is the section 1202 gain exclusion for “qualified small business stock,” available only to certain C corporation shareholders. This gain exclusion has many requirements, including the acquisition of stock at original issuance, holding the stock for at least five years, and conducting a “qualified business.” If all the requirements are met, a shareholder can exclude up to 100 percent of the gain from the sale of the stock. This gain exclusion, in combination with the 21 percent corporate tax rate, may make the C corporation form attractive for certain businesses.