Choice of Entity Under the New Tax Act: C Corporation
As the result of recent tax reforms, some business owners are considering incorporation or conversion to C Corporation status for tax purposes. Despite the appeal of a dramatic decrease in corporate tax rates, from a maximum of 35% to a flat 21%, and the elimination of the alternative minimum tax for corporations, there are several other factors that should be considered before making changes in entity status.
Business owners must consider their personal tax rates when assessing the benefits of conversion. Double taxation on corporate distributions continues to burden shareholders. Income is first taxed at the corporate level (21%) when earned and then is taxed again when distributed to shareholders, or when the corporation is sold (at a rate of 20% for most dividends and stock sales, but as high as 37% in certain circumstances). At the individual level, dividends and gains are also subject to net investment income tax at a rate of 3.8%.
Companies that intend to retain profits may benefit from the lower 21% tax rate, but keep in mind that there is an accumulated earnings tax, which is a penalty tax on undistributed profits.
For owners of pass-through entities and sole proprietors faced with entity decisions, the potential benefit of the new qualified business deduction (commonly referred to as QBI deduction) should be considered. The QBI deduction allows these business owners the opportunity to deduct up to 20% of income taxed at the individual level. For example, an owner of a qualified trade or business is taxed at a marginal rate of 37% but allowed a 20% deduction on qualified income. The effective rate on non-corporate earnings is 29.6%. Although this rate is higher than the 21% corporate rate, the double taxation issue mentioned above is no longer a factor.
One of the wrinkles of this tax strategy relates to businesses that are considered to be specified service trade or businesses (SSTB) for purposes of QBI; owners of SSTBs are limited in the amount of deduction that can be taken. Health, professional and consulting services are just some of the types of business that fall into the SSTB category. For taxpayers with adjusted gross income above $157,500 single/$315,000 married filing joint, the 20% deduction is gradually phased out. Additionally, the QBI deduction is limited to 50% of a company’s W2 wages or 2.5% of the unadjusted basis of assets of the company. High earning taxpayers that own a business deemed to be a SSTB, that have low wages and are not capital intensive, may benefit from conversion because they are limited to the QBI deduction.
Section 1202 should be taken into account when evaluating the benefits of C Corporation status. Section 1202 allows taxpayers to exclude up to 100% of the gain on sale of qualified small business stock (QSBS) if the stock has been held for more than five years and meets certain other requirements. The benefit of the 1202 exclusion needs to be considered over the life of the stock rather than just a single year. As mentioned earlier, the issue of double taxation is a factor, but if the goal is to reduce the gain realized on ultimate sale of the stock, the reduced tax in the year of sale may outweigh the year-to-year increase in taxes.
An additional factor that should be considered is the deduction for state taxes on an individual’s tax return, which is now limited to $10,000. If a company has significant tax liability in a number of states, conversion could be beneficial for state tax deduction purposes because there is no limit to the state deduction for corporations. If business owners analyze the effects of double taxation, QBI deduction, 1202 exclusion and state tax deductions, they may find conversion to be the best solution for limiting taxes. In this case, owners should keep in mind that legislation could change again, and the currently low corporate tax rate could rise in the future. Also, conversion could be costly, taking into account legal and tax filings as well as registration fees.
For further insight into the potential benefits of electing C corporation status, consult your tax professional.