The Effect of Tax Law Changes on Decisions Regarding Choice of Entity
As a result of the 2017 Tax Cuts and Jobs Act (TCJA), the 2020 Coronavirus Aid, Relief and Economic Securities (CARES) Act, and possible outcomes of the 2020 elections, business owners have a significant amount to consider when determining if their entities are set up in the most advantageous way possible for tax purposes.
Factors for Decision-Making: C-Corporation
The TCJA resulted in a dramatic decrease in corporate income tax rates from a maximum rate of 35% to a flat 21%. While on the surface the significant drop in rates is appealing to those contemplating conversion to C corporation status, business owners must consider their personal tax rates when assessing the benefits of conversion. The issue of double taxation on corporate distributions continues to burden shareholders. For C corporations, income is taxed at the corporate level at the 21% rate when earned by the entity and then taxed again when distributed to the shareholders, either in the form of a taxable dividend or when the corporation is sold. The individual dividend rate is generally 20%, but can be as high as 37% for certain dividends. In addition, under current legislation, for individuals, dividends and gains are subject to an additional 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 C corporation owners should keep in mind the accumulated earnings tax, which is an additional penalty on undistributed profits.
CARES ACT Provisions
During the 2020 tax year, the coronavirus pandemic added additional factors to consider when making decisions regarding entity selection. The CARES Act, signed into law on March 27, 2020, provides several tax-related benefits for businesses. Certain provisions are specifically beneficial to businesses operating as C-corporations.
Net Operating Losses
The CARES Act temporarily relaxes rules governing the use of net operating losses (NOLs) established under the TCJA. The TCJA limited the use of NOLs post-2017, to 80% of current year taxable income. Under the CARES Act, NOLs will no longer be subject to the 80% limitation for tax years beginning before 2021. However, for years beginning after 2021, the NOL deduction allowed will revert to the 80% limitation of current year taxable income for losses arising in tax years after 2017.
The CARES Act also temporarily modifies TCJA rules eliminating the ability for NOLs to be carried back to prior years in which a corporation had taxable income. The Act permits 100% of losses from tax years ending in 2018, 2019 and 2020 to be carried back to the five prior tax years. This creates the opportunity for C corporation taxpayers to file for possible refunds of tax liabilities paid in prior years, by carrying back NOLs to reduce previous taxable income.
Alternative Minimum Tax
The elimination of the corporate alternative minimum tax (AMT) was part of tax reform under the TCJA. The repeal of the AMT allowed corporations to claim outstanding AMT credits (subject to certain limitations) as refunds for years 2018 through 2020. The CARES Act allowed this process to be accelerated by permitting corporations to elect to claim a refund of any unused credits from 2018 as fully refundable.
Factors for Decision-Making: Pass-Through Entities
Unlike their C corporation counterparts, pass-through entities and sole proprietorships are (usually) not taxed at the corporate level and, therefore, may be attracted by the 21% reduced corporate tax rate introduced by the TCJA. However, if a company intends to pay dividends or could be sold within a relatively short period, a conversion to C corporation status may not be ideal because of the two levels of taxation.
Qualified Business Income Deduction
The Qualified Business Income (QBI) deduction allows business owners the opportunity to deduct up to 20% of income taxed at the individual level (i.e., self-employment income, income from pass-through entities). 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, resulting in an effective rate of 29.6%. Although this rate is higher than the 21% corporate rate, the double taxation issue mentioned above is minimized.
One of the wrinkles of the QBI deduction relates to businesses considered to be specified service trades or businesses (SSTB). For the purposes of QBI, these businesses are limited in the amount of deduction that can be taken. Health, professional, and consulting services are just some of the types of businesses that fall into the SSTB category. High-earning taxpayers owning a business deemed to be a SSTB are subject to limitations and should consider their wage levels, as well the level of capital needed to run their business. If they have low wages and are not capital–intensive, the taxpayer may benefit from conversion due to the limited QBI deduction.
Tax legislation has changed a great deal over the past few years and will continue to change in the future. The TCJA’s reduced corporate tax rate may be appealing to businesses considering conversion to or creation of a C corporation. However, various additional tax provisions must be considered in the conversion decision process. In addition to the factors associated with longstanding tax laws and the reform enacted by the TCJA, the CARES Act provides additional benefits for C corporations with net operating losses from prior years and potential losses in future years.
The 2020 election also could produce additional changes in tax legislation.
If thoughtful analysis concludes that establishing a C corporation is tax advantageous, owners should also consider the cost of legal services as well as tax filing and registration fees. For further insight into how current and future tax legislation may impact your business, consult your Marcum tax professional.