Choice of Entity Considerations Now that the Tax Cut and Jobs Act is Law
By Christopher Cheeseman, Partner, Tax & Business Services
In the wake of what many consider the most comprehensive tax overhaul since the Tax Reform Act of 1986, taxpayers are working with their tax advisors to analyze the impact of the new law on their tax planning. The Tax Cuts and Jobs Act of 2017 (the “Act”) includes a dramatic rate reduction for corporations; elimination of the corporate Alternative Minimum Tax (“AMT”), which is a parallel tax regime to ensure corporations pay some amount of tax; a deduction for Qualified Business Income (“QBI”) from pass-through entities and sole proprietors; and a comprehensive rate reduction for many individual taxpayers, to name just a few. Most of these changes become effective for the 2018 tax year.
Choice of Entity
The Act has prompted many taxpayers to reconsider the form of entity in which their businesses operate. For example, should you convert from an S Corporation or a limited liability company to a C Corporation, in light of the corporate rate change from a top rate of 35% to a flat tax rate of 21%? This is an especially important question, given the fact that the individual rates under the Act are higher than the new 21% corporate rate.
The Qualified Business Income Pass-Through Deduction, or Pass-Through Deduction for short is a new deduction available for individuals with QBI from Pass-Through entities including sole proprietorships for tax years beginning after December 31, 2017, and before tax years beginning January 1, 2026.
QBI is income, gain, deduction, and loss effectively connected with a U.S. trade or business, excluding investment type income. Thus, investment type income such as capital gain, dividend income, and investment interest income flowing through from the pass-through entity is excluded from QBI.
The deduction is a deduction from taxable income and not a deduction to arrive at adjusted gross income. The deduction is not available, with certain exceptions, for certain specified service type income, including income from the performance of services in accounting, actuarial sciences, athletics, brokerage services, consulting, financial services, health, law, performing arts, investments, and services whose principal asset is the reputation or skill of one or more of its owners.
The deduction, subject to limitations, is 20% of QBI. The deduction limitation is the greatest of 50% of W-2 wages paid by the pass-through entity, or 25% of the W-2 wages paid by the pass-through plus 2.5% of the unadjusted basis of certain property the business uses to produce qualified business income.
The above limitations do not apply to married filing joint taxpayers whose taxable income does not exceed $315,000 and phases in between $315,000 and $415,000 through a proration modification of the above limitation.
The deduction is subject to overall limitations. The 20% deduction cannot exceed the lesser of the taxpayer’s combined qualified business income or 20% of the taxpayer’s taxable income over the sum of the taxpayer’s net capital gain and the taxpayer’s aggregate qualified cooperative dividends, plus the lesser of the taxpayer’s aggregate qualified cooperative dividends or the taxpayer’s taxable income, minus the taxpayer’s net capital gain.
The new 20% deduction for certain pass-through entities and sole proprietors reduces the effective tax rate to 29.6%, assuming an individual taxpayer at the new highest individual tax rate of 37%. While this effective tax rate is greater than the new 21% corporate rate, it does not consider the “second-level” of tax on corporate earnings when such earnings are ultimately distributed to shareholders, generally at a dividend rate of 20%, depending on the individual’s income level. Taxpayers also need to consider the additional net investment income tax of 3.8% on such corporate distributions. After corporate taxes and dividend income taxes, taxpayers may be looking at an overall combined tax rate of 44.8%, as a result of operating as a C Corporation rather than an S Corporation or partnership. State and local tax deductions and other tax considerations add to the complexity of this type of analysis and make it much more difficult than appears on the surface.
The following summaries reflect the difficulties in analyzing the potential results of converting entity type under the new law only considering the new Pass-Through Deduction:
First, we examine the corporate rate reduction. The Act replaces a 35% top-rate graduated corporate schedule with a flat 21% tax applied to all corporate taxable income. Let us put some numbers to this and see the extent of the tax savings. A corporation with net taxable income of $500,000 under the old rates would have a tax liability of $170,000 [113,900 + ((500,000 – 335,000) X 34%)]. Under the new tax law, the tax is $105,000 [500,000 X 21%]. The rate reduction equals a $65,000 tax savings. Seen another way, under the Act, the corporation is paying less than 62% of what it would have under the old law, on $500,000 of taxable income.
Now, let us look at a corporation with much higher net taxable income of $25 million. Comparing the new flat rate of 21% to the former rate of 35% on corporations with taxable income in excess of $18,333,333 produces a tax of $5,250,000 under the Act and a tax of $8,750,000 under the former law. The corporation enjoys a 14% reduction in rate, saving $3.5 million in taxes, and pays 60% of what it would have under the old law.
Next we examine an S Corporation with $200,000 of compensation paid to its sole shareholder, and net taxable income of $300,000 passed through to the shareholder. (For this example we will ignore payroll taxes, including an additional Medicare tax of 0.9% under IRC §3101(b)(2), which was unaffected by the Act. We also ignore all deductions that may be available to the individual on the individual federal income tax return, for the sake of simplification).
The S Corporation’s sole shareholder’s wages of $200,000 plus her $300,000 in S Corporation earnings passed through to her is $500,000 of taxable income, which is the same amount of taxable income to the C Corporation in the first example above. The $500,000 of taxable income under the graduated income tax rate schedule produces a tax of $143,231 [131,628+((500,000-470,700) X 39.6%)] under the old law.
We will apply the same facts to the reduced rates on individual taxpayers under the new tax law but also assume that the $300,000 of income is QBI eligible for the new Pass-Through Deduction under IRC §199A of the Act. The tentative amount of the deduction is 20% of $300,000, or $60,000. Assuming that the entity limitation of 50% of W-2 wages paid is the greater of the two limitations described earlier, the deduction will be limited to $100,000, or 50% of the $200,000 W-2 wages paid by the entity.
Next we turn to the overall limitation. The taxpayer’s overall combined QBI is $300,000, and she has no capital gains nor qualified cooperative dividends to consider. Twenty percent of the taxpayer’s taxable income, and the limitation in this case, is $100,000.
Because $60,000 is less than both limitation amounts of $100,000 each, the deduction in computing taxable income is not limited, and the taxpayer deducts the full $60,000 from QBI in calculating taxable income on her individual income tax return. Therefore, taxable income is $440,000 computed as $200,000 wages + $300,000 pass-through QBI – $60,000 QBI 20% deduction. The tax on $440,000 of taxable income is $99,534, applying the rates under the Act.
What if the taxpayer had made an election to revoke her S Corporation status and became a C Corporation under the same facts above? To make an apples-to-apples comparison, we will assume that the corporation will distribute all of its net taxable earnings in the form of a taxable qualified dividend to its sole shareholder.
The corporation will pay tax at 21% on its net taxable income of $300,000, or $63,000. The corporation will then retain $63,000 to pay the federal income tax and issue the $237,000 net cash as a dividend to its sole shareholder.
The taxpayer has $237,000 of qualified dividend income and $200,000 of wages that will be included as taxable income on her individual tax return. She pays $72,129 of tax, computed by multiplying her qualified dividends by the 15% qualified dividend income for her level of income and running her wage income through the rate tables under the Act.
The total tax for the corporation and the sole shareholder combined is $135,129. Comparing the results of operating as a C Corporation to the total tax above vs. operating as an S Corporation, we see that the S Corporation form comes with a lower tax bill in this case.
There are many factors to consider before deciding whether to change your entity’s current structure, or determining the best tax structure for a new business. The anticipated federal tax rate on earnings, including the second level of tax on the distribution of C Corporation earnings, is a good starting point. But, there are many other tax and business considerations, including state taxes and the complex new laws for taxation of foreign operations that must be carefully reviewed before you make this decision. Your Marcum tax advisors and your legal counsel can help guide you through this complex but important process.