What form of entity is best suited for your business? The answer to this question involves a variety of considerations and has been further complicated with new tax reform under the Tax Cuts and Jobs Act (TCJA). The choices include C-corporation, S-corporation, partnership (LLC/LLP), or sole proprietorship. Each entity option carries with it different tax, legal, and operational implications
While TCJA made many changes to business and individual taxpayers, the three most prominent changes that would impact the choice of entity decision are the reduction in the corporate tax rate to 21%, the new Qualified Business Income Deduction (QBID), and the requirement to include the income of a controlled foreign corporation (CFC) in US taxable income for those taxpayers who own CFCs.
While a deep analysis of each consideration is beyond the scope of this article, we did want to point out that the decision should be made in concert with your CPA firm/tax professional and attorney. There are a variety of considerations such as level of flexibility, equity structure, succession planning, and protection that all play part in the choice of entity or structure that you choose.
Below we have included a discussion of some of the additional considerations now further contemplated with the new tax reform.
The top corporate rate was reduced from 35% (graduated rates) to 21% (flat rate). This compares with a top individual rate of 37%. While C Corporations now have a flat 21% tax rate, the lowest favorable 15% bracket has been removed. In addition, C Corporations still face double taxation when issuing dividends to its owners. Below we have included some additional factors to consider when contemplating a C Corporation:
- What is a good balance between owner compensation and corporate income? The IRS expects that a business owner will take “reasonable compensation”, a term that is not well defined. Compensation is deductible from corporate income, leaving a lower corporate taxable income subject to the 21% rate. At the owner’s level, the compensation is taxable at ordinary income rates, which run from 10% to 37%. For a married couple filing a joint return, taxable income from $77,400 to $165,000 is taxed at a 22% rate. Taxable income from $165,000 to $315,000 is taxed at a 24% rate. One option to be contemplated as part of C Corporation planning is to manage a corporation’s bottom line to approach a fairly even split between corporate income and owner compensation, assuming the owner is comfortable with income in the above ranges (and that the company can support that level of compensation).
- Does the owner plan to distribute corporate after-tax income in the form of dividends? This results in double taxation because the dividend is taxable at the individual level. Even though qualified dividends are taxed at a lower rate, the overall tax could be higher than if the owner took more compensation. Let’s assume that the owner’s income is high enough that the dividend is taxable at the 20% favorable rate, plus another 3.8% for the Net Investment Income Tax. Adding that to the 21% corporate rate gives a combined tax of 44.8% versus the highest individual rate of 37%.
- If the owner plans to retain earnings within the company to reinvest in the business, a C-corporation might be a good option to consider. Note however that the corporation could potentially be subject to the Accumulated Earnings Tax, which is on top of the regular income tax, if the company does not have plans to put those accumulated earnings to good use. If the owner plans to distribute most or all the company’s current year income, a pass-through entity does tend to be more tax effective particularly given the new 20% pass through deduction available.
- Does the owner expect losses, especially in the early years? If so, as a corporation there would be no tax, but a loss carryforward. However, if the business were run as a pass-through entity, the owner could avail him- or herself of the losses on the individual return to potentially offset other income. Keep in mind, though, that another new twist in the tax law is that a non-corporate taxpayer may offset other income with only $250,000 in business losses ($500,000 on a joint return). Any disallowed loss is carried forward and treated as a net operating loss (NOL). Plus, NOLs are now limited to 80% of taxable income (before the NOL).
- Capital raise, ownership structure, and the ultimate goals of the company may also impact your choice of entity. For example, the C Corporate form of business (as well as the LLC/partnership entity) can have foreign owners. Many private equity firms, if part of your planned equity structure, often prefer the C Corporation form of business to avoid the administrative headaches of K-1s out to the owners and the flow-through nature of income. Does the owner plan to eventually take the company public? If so, the business owners would need to eventually convert to the C Corporate form of business.
- Contemplation of future sale may also impact your selection of a C-corporation. If you anticipate an ‘asset sale’ in the future, C-corporations are often not tax efficient as the double taxation element and non-recognition of capital gain come into play. If you anticipate a ‘stock sale’ down the road, the C-corporate form of business may afford you exclusion of all or a significant portion of the sale under Section 1202 (assuming original issuance stock is held 5 years or more and other criteria are met).
- Finally, it should be noted that nothing prevents Congress from increasing the corporate tax rate at any time in the future.
Pass Through Entities and the Qualified Business Income Deduction (QBI)
This newly enacted tax provision allows the owners of pass-through entities (S-Corporations, Partnerships, LLCs, and sole proprietorships) to deduct 20% of their net pass-through profits. There are various restrictions and limitations based on factors such as taxable income, W-2 wages paid, the level of depreciable tangible property the company owns, and even the type of business. The mechanics of this deduction are beyond the scope of this article, but you can reference another technical piece we completed on this topic.
The purpose of this deduction is to approximate the reduced 21% corporate tax rate for the owners of pass-through entities. As a result, an analysis would be recommended to determine whether, for tax purposes, the owner would be better off running a business in C-corporation form or in a pass-through entity.
Just as with the discussion regarding corporations, there is a balance to be struck between owner compensation and pass-through income. The owner’s salary reduces the pass-through income for purposes of the QBI deduction – but the salary itself is not considered QBI at the owner’s level. Thus, there is a similar trade-off between the QBI deduction and the top individual rate of 37%.
Income from a Controlled Foreign Corporation (CFC)
TCJA also changed the nature of reporting income from a CFC. Previously, this income was includible in US income only if the owner received an actual distribution from the CFC. For 2017 only, US taxpayers were required to include in their income all post-1986 earnings & profits of a CFC.
Going forward, this CFC income must be included in US income. The calculation of the amount to include is complicated and also beyond the scope of this article.
Corporate shareholders may deduct 50% of the income inclusions and may claim a foreign tax credit on this income at the corporate level. These provisions do not apply to non-corporate taxpayers. Note that an individual taxpayer may make an affirmative election to be taxed on the CFC income at reduced rates under a corporate context. While not receiving all of the C Corporate rate benefits, the election does make the tax impact more comparable. Again, a determination should be made to decide which type of entity is more beneficial in this circumstance.
As mentioned, the choice of entity for your business requires planning and discussion and should be completed in concert with your tax professional and legal counsel.
We would be happy to review any choice of entity considerations as you contemplate your situation. If you would like to discuss tax planning in this or any other areas of Tax Reform, please feel free to contact us