The math has changed on entity choice. Under the new tax reform legislation, the corporate tax rate drops a full 14 points, from 35 percent to 21 percent. At the same time, the top individual rate is lowered only 2.6 points, from 39.6 percent to 37 percent. This means the spread between corporate rates and the individual rates that apply to pass throughs, such as partnerships and S corporations, has widened dramatically. Many owners of businesses taxed as pass throughs are therefore wondering if now is the time to switch to C corporation status.
The answer, as is usually the case when it comes to taxes, is……it depends.
First, business owners need to understand that this is a long-term decision. Partnerships that make the switch are effectively making a permanent decision—there is no tax efficient option to switch back. On the other hand, S corporations that switch to C corporation status are effectively making a 10 year decision – S Corporations are precluded from reverting back to C for five years, and, then, at that point face a 5-year period during which they could face additional taxes for built-in gains on re-conversion. Therefore, given the long term nature of the decision, business owners need to consider a variety of issues besides rate spreads, including:
- The chances that future legislation could change rates again
- Their exit strategy, including how tax status could affect issues like tax basis in the shares, sales price premium from the ability to sell assets, and the small business stock exclusion
- Their business succession and perpetuation strategy, and the ability to transfer ownership in the business in the most tax efficient manner
- After-tax liquidity needs of both the business and the owners
- Questions concerning the availability of losses and the tax basis in their shares
- Cost to convert back to pass through status, should it become necessary
- How ownership status will affect new capital investment
- Effect on equity compensation programs
- Whether rate reduction will allow new growth opportunities for the business and the ability of the business to generate a meaningful return on those savings
But, for many business owners, the decision will come down to the numbers—whether and how much they would save by making the switch. Answering the following three questions will help them make that decision.
What are your current and future distribution requirements?
Whether and how much income your business distributes to its owners will play a key role in determining the real after-tax benefits of C corporation versus pass through status. Income distributed as dividends to C corporation owners is taxable to them, creating two layers of tax—first the corporate income tax is paid by the corporation on its earning from business operations; and, then the individual owner pays income tax on the dividends paid by the corporation from the “after tax” earnings from the business.
The after-tax picture for businesses in growth mode that plan to retain all or most of their earnings to reinvest in the business is very different from that of a business that will distribute the bulk of its earnings to its owners via dividends. How different? While the federal corporate tax rate has dropped to 21 percent, the overall effective federal rate to the highest-bracket owners of a C corporation that distributes all of its “after tax” earnings would be 39.8 percent (This is actually 2.8 percentage points higher than the new 37 percent top federal personal income tax rate.) But the overall effective federal rate for owners of a C corporation that makes no distributions would be only 21 percent,
How will the new Section 199A deduction affect your FTE tax picture?
The new tax reform legislation creates a maximum 20% deduction on income from certain pass-throughs. Assuming the full 199A deduction is available, the top rate for owners of a pass-through would be reduced from 37% to 29.6%. Thus, the new 199A deduction
, combined with other factors, could make remaining a pass-through more attractive for many owners despite the significant reduction in C corporation rates.
Final regulations approved by the IRS Jan. 18, 2019, have answered most, but not all questions about interpreting the new regulation. The good news is still that most owners of domestic pass-throughs should be eligible for the full benefit. The major eligibility exception — specified service trades or businesses (SSTB) where the principal asset is the reputation or skill of one or more of its employees or owners — is now better defined. The final regulations make clear that defining what portion of a pass-through business is considered part of an SSTB is crucial, though determining that can be a detailed and even tedious process.
Consider this example of a dentist who owns a building and rents half of it to another unrelated business. With the final regulations, only the portion of the building where the dentist works is part of the SSTB. Before the final regulations, it was possible the whole building could have been considered part of the SSTB and thus not an asset eligible to be figured into the deduction.
How will state taxes affect your overall tax picture?
The new tax legislation significantly limits an individual taxpayer’s ability to deduct state and local incomes taxes. At the same time, state and local taxes remain deductible for corporations. What’s more, how these taxes are calculated and paid differ between C corporations and pass throughs. Determining the overall tax impact of state and local taxes at both the corporate and individual level should play a key role in any decision concerning ownership status. Obviously, pass through owners who live and whose businesses operate in low- or no-tax jurisdictions face a far more favorable situation than those living in high-tax states. But, this will not help the business if there are other owners living in higher taxing jurisdictions and if the tax reimbursement policy involves reimbursing at the highest combined federal and state rate.
What about other considerations?
A variety of other issues also need to be considered.
Under the new law, the tax reimbursement policies of pass throughs must be revisited. Different owners could have very different tax burdens depending on their state and whether they are eligible for the Section 199A deduction. Under the new law, the rates and thresholds for Medicare taxes are unchanged with the top rate remaining at 3.8 percent, but Medicare taxes need to be included in your tax considerations, especially for passive owners of pass throughs, as switching to C- corporation status could affect Medicare tax liabilities.
The structure of any succession plan, especially those using trusts, needs to be considered. Many pass through owners use trusts, and their succession plans often depend on the tax efficiencies of pass through status. Owners considering a switch to C corporation status will need to reevaluate these plans. Further, the top estate tax rate remains at 40 percent, but the exemption is doubled from $5.6 million to $11.2 million. pass through owners considering a change should be sure to consider how the liquidity needs to fund these taxes will be addressed.
What’s the big picture?
The after-tax picture combining all of these issues can be determined only by considering all of the facts and circumstances of any business. Statutory rates alone tell only part of the story. Only through analysis of your unique situation and goals can you determine the right decision.
Director, Washington National Tax Office
+1 202 861 4144
Managing Director, Private Wealth Services
+1 414 277 6411