Will Tax Reform Make C Corps Cool Again?|
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By the end of the 1980s, closely-held C corporations mostly went the way of Members Only jackets and the Commodore 64. Pass-through entities have since become the tax structure of choice for most small to mid-size businesses. Could Trump tax reform alter that trend?
A (Very) Brief History of Corporate Entities
Sole proprietorships, partnerships, LLCs and S corporations are pass-through (or flow-through) entities. They are so named because business profits are taxed at the individual level, via the owner or owners, rather than at the entity level.
Through most of the 20th century, C corporations were the preferred entity structures for all types of U.S. businesses, thanks to a low corporate tax rate.
This trend changed when Congress passed the Tax Reform Act of 1986, which lowered individual income tax rates from 50% to 28%. The number of pass-through entity structures exploded, in part because of the preferential tax rates, but also because flow-through entities require simpler administration and remove the double taxation barrier.
Late last year, Congress passed another sweeping tax bill – the most impactful change since the 1986 Act. The Tax Cuts and Jobs Act (TCJA) of 2017 made the corporate tax rate much more attractive to business owners.
Will tax reform allow C corporations to reclaim their popularity?
One of the TCJA’s most impactful changes was lowering the corporate tax rate from 35 percent to a flat rate of 21 percent. This tax rate is not only the lowest it has been in decades, but it is much more globally competitive and is lower than individual rates.
Individual rates also decreased under the TCJA, but not to the same extent. The maximum federal individual income tax rate decreased from 39.6 percent to 37 percent.
To address such a large discrepancy between the corporate and individual tax rates, Congress created the Qualified Business Income Deduction (QBI). This deduction is available to many flow-through business owners and can reduce flow-through taxable income by 20 percent.
This 20 percent deduction is not available to business owners in certain service industries (including law, consulting and performing arts) that have income above a certain threshold. Those who do qualify for the deduction can see a significant reduction in their effective tax rates, potentially down to a low 29.6 percent after considering the impact of the QBI deduction.
Should You Reconsider the C Corporation?
Your growth plans should impact your entity selection. Corporations that reinvest earnings do not subject owners to double taxation, leaving in effect the low 21 percent tax rate.
However, to get cash into the hands of C corporation owners, income will still be taxed at the corporate level and again at the individual level. Even though dividends are taxed favorably to other types of income, double taxation can bring the total effective tax rate up to 39.8 percent to get cash out of a C corporation. That is much higher than the 29.6 percent effective tax rates for flow-through earners who utilize the Qualified Business Income Deduction.
Exit Strategy Matters, Too
Closely-held business owners also should consider their exit strategy. A C corporation owner can exit her business by selling company stock or by selling assets. Buyers often prefer to purchase corporate assets so they can receive the benefits of a stepped-up basis in their investments. But a C corporation owner would be double taxed if they were to sell assets and then distribute the cash.
Alternatively, flow-through entity owners who sell company assets benefit from a much lower rate. Often, most of the gain on selling assets is taxed at a capital gain tax rate of 20 percent – a much lower number than those of taxpayers subject to double taxation.
Summary: Making the Right Choice
Selecting the right entity structure for your business is complicated, and recent changes to tax law have shaken up the status quo. Entity selection is a strategic business decision. Here’s what to consider:
- Growth plans
- Exit strategy
- Owner(s) tax strategies
This year it’s cool to be “old school,” but not when it comes to tax strategy. Consult a qualified advisor to find out whether your current entity structure still fits.