August 7, 2018

Cody Attisha contributes “Choice-of-Entity in a New Business Landscape” to Corp! Magazine’s July/August 2018 issue

Choice-of-Entity in a New Business Tax Landscape

Determining the type of legal entity used to operate a business is a crucial decision with significant tax and other legal implications that every business owner should be aware of. For tax purposes, an entity may either be taxed as a “pass-through entity” or a C corporation. A pass-through entity is a business structure where no tax is imposed at the entity level. Instead, the income/loss of the business is reported directly on the owner’s tax return. A sole proprietorship, partnership and S corporation are all examples of pass-through entities. On the other hand, a C corporation is taxed directly on its earnings and the owners are subject to an additional tax upon receiving dividends from the C corporation. This second level of tax is often referred to as “double taxation.”

On December 22, 2017 President Donald Trump signed into law the “Tax Cuts and Jobs Act of 2017” (TCJA). The TCJA reduced the income tax rate for C corporations from a top progressive rate of 35% to a flat 21% rate. With the passage of the TCJA, business owners should continuously evaluate choice-of-entity for both new business formations and also for restructuring current business operations. In particular, this drastic tax cut for C corporations has many business owners wondering whether greater tax savings may be achieved by operating as a C corporation as opposed to a pass-through entity. Under the TCJA, C corporations are taxed at a flat rate of 21% and individuals are subject to a top rate of 37%. Although the tax rate imposed on C corporations is generally lower than the highest individual tax rate, it is important to keep in mind that shareholders will bear an additional burden of tax on dividends paid by the C corporation. Dividends are taxed at a maximum rate of 20% but may be subject to an additional 3.8% net investment income tax. After considering the double tax imposed, the tax burden for C corporations and its shareholders is 39.8%. Thus, if a business owner expects to receive frequent distributions of earnings from the business, then operating as a C corporation will likely result in a higher overall tax burden than if the business were structured as a pass-through entity.

Another major highlight of the TCJA and a key factor to consider in evaluating choice- of-entity, is the ability for certain taxpayers to deduct up to 20% of “Qualified Business Income” (QBI) from a domestic partnership, S corporation or sole proprietorship, reducing the top individual tax rate from 37% to 29.6%. Single taxpayers with taxable income of less than $157,500 ($315,000 Married Filing Jointly) qualify for the full 20% deduction without any limitations. Once taxable income exceeds these levels, the deduction is limited to (i) the lesser of 20% of QBI or (ii) the greater of 50% of wages or 25% of wages plus 2.5% of the cost of depreciable property. Taxpayers operating certain service businesses and with taxable income above $207,500 (for single) and $415,000 (married filing jointly) are not eligible for the QBI deduction. The QBI deduction is an attractive feature of the TCJA that may tilt the balance to many business owners in favor of operating as a flow-through entity.

As more businesses begin to operate on a global scale, it is important to note that the TCJA introduced a host of complexities and changes in the international tax rules in an attempt to move towards a more territorial system of taxation. One such change allows U.S. C corporations to deduct 100% of the foreign source portion of certain dividends (subject to complex rules). This deduction is not available to pass-through entities.  In general, for federal income tax purposes, it is more beneficial for an owner of a foreign corporation to be a C corporation as opposed to a pass-through entity.

In contemplating the sale of a business, one may be wondering whether it makes sense to convert from a pass-through entity to a C corporation prior to the sale in order to take advantage of the new 21% corporate tax rate. In the majority of situations, the conversion to a C corporation prior to a sale will not provide tax benefits to the seller. A sale of assets by a C corporation results in double taxation to the seller, eliminating any benefit of the reduced corporate income tax rate. Also, a large portion of the gain in a sale of assets is allocated to goodwill which is taxed to individuals at favorable capital gain rates that are lower than the corporate income tax rate. Often times, the buyer of a business pushes to acquire the assets as opposed to the stock or equity. This is largely due to the fact that the buyer obtains a “stepped-up” basis in the assets at cost price which allows for larger depreciation deductions. An asset deal also allows the buyer to pick and choose certain assets and refrain from acquiring any liabilities of the seller. With the popularity of asset deals, it is important for sellers to keep in mind that the sale of certain depreciable business assets will trigger depreciation recapture taxed at the higher ordinary income rates as opposed to favorable capital gain rates

When it comes to choice-of-entity under the TCJA, there is no such thing as a one-size-fits-all approach. Whether a business should operate as a C corporation or a pass- through entity depends on a multitude of factors including:

  • the type of business being operated (i.e. service business, retail, manufacturing, real estate, etc.);
  • the amount of wages being paid to employees;
  • whether the business intends on accumulating earnings over the long-term versus making periodic distributions to its shareholders;
  • whether the business has foreign operations or intends on entering international markets; and
  • sale of business/exit strategies .

In light of the numerous tax law changes introduced by the TCJA, business owners should work closely with their tax advisors to continuously evaluate choice-of-entity considerations.

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