Tax Reform and the Art of Entity Selection
May 17, 2018 | Randy Mihm, CPA, JD
The Tax Cuts and Jobs Act made significant, wide-sweeping changes to the tax code for corporations. C-corporations saw the previous top tax rate of 35 percent cut to a flat 21 percent. Additionally, a new Qualified Business Income (QBI) deduction for S-corporations, partnerships and sole proprietorships was adopted. This change did, however, come with some industry restrictions; some personal service businesses were excluded from the special rate in certain situations.
These changes will leave many business owners and those with pass-through income wondering where they fall in the lineup of tax rates and deductions. Some are beginning to question if a switch from S-corporation to C-corporation would be beneficial in light of these changes. While each choice of entity presents tax opportunities and challenges of its own to consider, each business’s unique needs and goals should also be taken into account before making an entity switch. Entity selection is an art rather than a science; this was true before tax reform passed, and it continues after this tax reform legislation. However, in light of these recent changes, it is prudent to once again discuss and weigh this choice with the potential outcomes and results.
For qualifying C-corporations, the 21 percent federal tax rate, while favorable for some, can be misleading to those contemplating a change from S to C. A C-corporation will have state tax in most states, so combining the 21 percent federal rate with a state tax of 5-9 percent creates a combined rate approaching 26-30 percent. At the individual level, the top 23.8 percent federal dividend rate, along with a state tax on dividends, may combine to create rates approaching 30 percent. Combined, this adds up to over 50 percent.
Consider this example: Assume you are a C-corporation making $1 million before tax where the after-tax income is intended to be distributed to shareholders. The corporate tax could be about $300,000, leaving $700,000 to distribute as a dividend. The tax on a $700,000 dividend could be about $210,000, leaving $490,000 of after tax proceeds in the hands of shareholders. This combined rate of tax is 51 percent on income taxed to a C-corporation subject to full state taxation and then distributed as a dividend.
To take this one step further, consider the S-corporation entity structure where the top federal individual tax rate for ordinary income is 37 percent. The new QBI deduction is 20 percent of QBI, resulting in an effective top rate of 29.6 percent of ordinary income eligible for the QBI deduction. It is not currently known, nor do we expect a quick answer, if the states will adopt the QBI deduction, but for our purposes, we will assume they will not. For income at the top rate of 37 percent and common top state taxes of 5-9 percent, the top combined rate for pass-through income not eligible for the QBI deduction may approach 42-46 percent. However, the single tax structure of pass-through entities remains after tax reform, so this combined tax rate compares favorably with the potential combined tax rate of 51 percent for C-corporation income, which is subject to double tax. For income at the top rate of 29.6 percent and common top state taxes of 5-9 percent, the top combined rate for pass-through income eligible for the QBI deduction may approach 35-40 percent.
These two scenarios are basic examples designed to illustrate what the corporate tax rate reduction could mean for the S- and C-corporation entity structures. Each business is unique, and the definition and interpretation of which personal service corporations qualify for and which are excluded from the QBI deduction will make for an even more complicated road ahead. Taxpayers and their accountants will need to continue to explore what these changes mean for their specific industry and tax situation. Choice of entity is not a blanket selection that can be made across industries; rather it is an art of understanding each individual business’s structure, needs and goals to choose the entity, which provides the optimal path to maximum opportunities both now and in the future.