Businesses and individuals are still trying to wrap their heads around the new Tax Cuts and Jobs Act (TCJA), which will impact them throughout 2018 and beyond. However, one burning question many owners of pass-through entities — such as S Corporations, LLCs and partnerships — are asking is:
‘Should we become a C Corporation now that the new corporate tax rate has been lowered to 21%?’
It’s a great question. The answer is — maybe, but not necessarily. One of the key diligence items to analyze is the double taxation that distribution-making corporations face. Then compare it to your overall tax strategy and business goals.
Here are the raw numbers to consider:
The new corporate tax rate is a flat 21%.
The new highest individual rate is 37%, which combined with the 20% qualified business income deduction for pass-through entities can create an effective tax rate of 29.6% (for taxpayers unrestricted by the limitations or exclusions of the deduction).
If a pass-through entity’s income does not qualify for the 20% business deduction, the rate will top out at 37%.
While it may seem that the 21% corporate rate is clearly the better option for growing businesses looking for income to reinvest back into the business, you first must consider the ultimate outcome of a corporation’s tax. If the entity distributes dividends, shareholders must add the shareholder tax rate to the 21% corporate rate. That combined rate equals 36.8% — which would be roughly the same as a pass-through entity that does not qualify for the qualified business income deduction, and higher than pass-through entities that can take the deduction. Also, the interplay of the net investment income tax and the expanded Medicare tax would need to be taken into account as well.
Another consideration is the impact of non-deductible expenses. If a business has significant non-deductible expenses (entertainment, meals, 280E, etc.), the tax cost of those non-deductibles could be significantly higher to the pass-through owner versus the C Corporation.
Finally, it’s important to consider the permanency of the corporate tax rate. That rate will be available until legislation changes it again, while the 20% pass-through business deduction and the new individual tax rates both expire in 2025.
The best solution is to run the numbers for your particular situation, taking into account use of business-generated cash, succession plans for the business, the potential of future legislation, etc. The interplay of various factors could lead to vastly different conclusions on a case-by-case basis.
For now, some taxpayers may benefit from remaining a pass-through entity rather than changing to a C Corporation. Before making that decision, however, companies and their owners will need to thoughtfully evaluate the options and their goals to get a clearer picture.
Please contact a memeber of your service team, or contact Tony Bakale at tbakale@cohencpa.com for further discussion.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.