The Tax Cuts and Jobs Act (“TCJA”) contains material changes to the U.S. tax system, many of which significantly impact the level of Federal income tax on business profits. Two changes which have received a lot of attention involve the new 20 percent deduction for qualified business income from eligible pass-through entities (e.g., S Corporations and partnerships) and the flat 21 percent rate on C Corporation income.
An owner of a pass-through business may take some satisfaction in a lower Federal tax liability under the TCJA. Assuming the business generates qualified business income, the top effective Federal rate may now be 29.6 percent after the impact of a 20 percent deduction before paying tax at a top Federal rate of 37 percent (the 20 percent deduction is the equivalent of a 7.4 percent tax rate reduction).
However, the Federal tax rate on the same business would be a flat 21 percent if it were a C Corporation. Why be happy with 29.6 percent when an alternative of 21 percent is available? Plus, that lower rate may be combined with full deductibility of state and local tax on C Corporation profit, whereas the new $10,000 cap on itemized deductions severely restricts deductibility of such taxes for owners of pass-through entities.
If an analysis of the pros and cons of pass-through versus C Corporation taxation stopped there, the answer would be clear. A C Corporation would appear to be the better economic answer under the TCJA. However, the analysis should not, in most circumstances, be limited to rates and deductibility of state and local taxes.
Unfortunately, this is where the exercise can get both confusing and imprecise. Here are a few other factors that come into play.
Exit Strategy for the Business Owners
In the event of a sale to another party, the potential buyer is generally interested in maximizing tax write-offs associated with purchase consideration paid. A purchase of C Corporation stock does not usually yield a great result in this regard. Purchasing the assets typically makes more sense.
This results in a first level of tax at the 21 percent flat C Corporation rate and then a second level of tax as the remaining sale proceeds are taxed at 23.8 percent (top long term capital gain rate of 20 percent plus 3.8 percent net investment income rate). This can yield a combined Federal tax rate of just under 40 percent on the gain arising from the sale of a C Corporation business. That may materially outweigh the economic savings of the 21 percent flat rate on profits from operations in the years prior to sale.
If a taxable sale is not the likely exit strategy for owners (e.g., ownership will pass to other family members via inheritance), the relative importance of this circumstance may be discounted.
Profits
The advantage of a flat 21 percent C Corporation tax rate over an effective pass-through rate of 29.6 percent can be diminished if owners intend to withdraw most of the profits of the business as opposed to allowing them to accumulate within the corporation. Be careful, however, because the IRS may assert that amounts in excess of the reasonable needs of the business should be subject to the accumulated earnings tax.
Compensation and Dividends
Owners of pass-through businesses with qualifying business income may aim for relatively low personal compensation, since it may be taxed at a 37 percent rate plus Medicare and perhaps a local earned income tax. The pass-through entity will receive a deduction, however, the tax benefit received is at the 29.6 percent rate. Pass-through income which can be matched with distributions will potentially yield a lower tax than salary income. IRS examiners will be aware of this circumstance and may challenge salary levels deemed to be too low.
In the case of a C Corporation, an owner may prefer to take a higher salary that, although subject to a higher tax rate, may still yield a better outcome than receiving dividend income. Dividend payments yield no deduction to the corporation to potentially mitigate the tax paid by the recipient. New rules relating to how S Corporation accumulated earnings are taxed when distributed after a qualifying revocation of an S election can reduce the tax consequences that can result. Where salaries are a better answer, IRS examiners may challenge compensation levels perceived as being too high.
Losses
Some businesses may experience material year-to-year profit swings, incurring losses in some years. New TCJA rules may limit the ability to offset a pass-through entity owner’s share of current year loss against other current year non-business income. However, C Corporation loss utilization provisions can be more onerous. Carrybacks of losses incurred in years ending after December 31, 2017 are no longer permitted. And, the carry forward of losses to offset profits of the corporation in a future year is subject to limitations that are more restrictive than in the past.
Additional Factors
There are a variety of other factors to consider when weighing C Corporation vs. S Corporation tax treatment. Examples include:
- The level of C and S Corporation earnings that have accumulated within the business when the change in tax status would be carried out.
- The possibility of a change in status from a C Corporation back to an S Corporation. Generally, once an S election is revoked, entities must wait five years to reelect S status.
- The possibility of a sale or other disposition event-triggering gain once S status would be reelected. An onerous built-in gains tax can arise during a five year period beginning with the reelection date.
The evaluation of C Corporation versus pass-through entity status should go beyond a simple comparison of the 21 percent flat C Corporation rate to a potential 29.6 percent pass-through entity rate. There are many other factors to consider and they are highly dependent on your company’s individual circumstances. We welcome a discussion with you about how to determine what is right for your business.