The Tax Cuts and Jobs Act (TCJA) introduced a flat 21% federal income tax rate for C corporations for the 2018 tax years and beyond. Previously, profitable C corporations paid up to 35%. This news has caused many business owners in Maine and elsewhere to ask: What is the best choice of entity for my start-up business?
Choosing the Optimal Business Structure
Under the old tax law, the conventional wisdom was that the majority of small and midsize businesses should be set up as sole proprietorships, or so-called “pass-through entities.” This would include:
- Single-member limited liability companies (LLCs) treated as sole proprietorships for tax purposes,
- LLCs treated as partnerships for tax purposes, and
- S corporations.
The major reason that pass-through entities have been popular was that income from C corporations may potentially be taxed twice. Initially, the C corporation pays entity-level income tax. And then, corporate shareholders pay tax on dividends and capital gains. Using pass-through entities avoids the double taxation issue since there is no federal income tax at the entity level.
Even though C corporations are still potentially subject to double taxation under the TCJA, the new 21% corporate federal income tax rate helps even out the playing field between C corporations and pass-through entities.
The subject is complicated by another provision of the TCJA that allows non-corporate owners of pass-through entities to take a deduction of up to 20% on qualified business income (QBI). This break is available to eligible individuals, estates, and trusts and generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.
Not surprisingly, there’s no universal “right” answer when determining how to structure your business to minimize the tax burden. Your best answer depends on your business’s unique situation and your situation as an owner. Here are three common scenarios and choice-of-entity implications to help you decide what’s right for your entrepreneurial venture.
- Business Generates Tax Losses
If your business consistently produces losses, there is no tax advantage to organizing as a C corporation. Losses from C corporations can not be deducted by the owners. In this case, it likely makes sense to operate as a pass-through entity. Then the losses will pass through to your personal tax return (on Schedule C, E, or F, depending on the type of entity you choose).
- All Business Profits Distributed to Owners
Let’s assume your business is profitable and pays out all of its income to the owners. Here are the implications of operating as a C corporation vs. a pass-through entity in this scenario.
C corporation results: After having paid the flat 21% federal income tax rate at the corporate level, the corporation pays out all of the after-tax profits to its shareholders as taxable dividends eligible for the 20% maximum federal rate.
So, the maximum combined effective federal income tax rate on the business’s profits — including the 3.8% net investment income tax (NIIT) on dividends received by shareholders — is 39.8%. That is 21% for the corporate level tax, plus the personal level tax rate on the dividends, which are reduced by the corporate level tax [(20% + 3.8%) x (100% – 20%)]. While you do still have double taxation here, the 39.8% rate is lower than it would have been previously.
Pass-through entity results: For a pass-through entity that pays out all of its profits to the owners, the maximum effective federal income tax rate on the venture’s profits is 40.8%. That equals the highest federal income tax rate for individuals (37%), plus 3.8% for the NIIT or 3.8% for the Medicare tax portion of the self-employment (SE) tax (whichever applies). This example does assume that, if the SE tax applies, the additional 0.9% Medicare tax on high earners increases the rate for the Medicare tax portion of the SE tax to 3.8%.
If you are able to claim the full 20% QBI deduction, the maximum federal income tax rate is reduced to 33.4%. That is the highest federal income tax rate for individuals on passed-through income reduced to reflect the QBI deduction [37% x (100% – 20%)], plus 3.8% for the NIIT or 3.8% for the Medicare tax portion of the SE tax (whichever applies). Note, the QBI deduction is allowed only for 2018 through 2025, unless Congress extends it.
In this situation, operating as a pass-through entity is likely the way to go if significant QBI deductions are available. If not, it’s essentially a toss-up although operating as a C corporation may be simpler from a tax perspective.
- Business Retains All Profits to Finance Growth
Finally, let’s suppose your business is profitable, but it keeps all profits to fund future growth strategies. Here are the implications of operating as a C corporation vs. a pass-through entity in this case.
C corporation results: This time, we will assume that retained profits increase the value of the corporation’s stock dollar-for-dollar, and that shareholders eventually sell the shares and pay federal income tax at the maximum 20% rate for long-term capital gains.
The maximum effective combined federal income tax rate on the venture’s profits is 39.8%. That is 21% for the corporate level tax, plus the personal level tax on gain that is reduced to reflect the 21% corporate tax [(20% + 3.8%) x (100% – 21%)]. Again, while you would still have double taxation, the 39.8% rate is better than it would have been under the previous law. In addition, shareholder-level tax on stock sale gains is deferred until the stock is sold.
If the corporation is a qualified small business corporation (QSBC), the 100% gain exclusion may be available for stock sale gains. In that case, the maximum combined effective federal income tax rate on the venture’s profits can be as low as 21%. Ask your tax advisor if your venture is eligible for QSBC status.
Pass-through entity results: Using similar assumptions for a pass-through entity, the maximum effective federal income tax rate on the venture’s profits is 40.8%. That is the highest federal income tax rate for individuals (37%), plus 3.8% for the NIIT or 3.8% for the Medicare tax portion of the SE tax (whichever applies). That’s slightly higher than the 39.8% rate that applies with the C corporation option.
But here’s the key difference: For a pass-through entity, all taxes are due in the year that income is reported. For a C corporation, the shareholder-level tax on stock sale gains is deferred until the shares are sold.
If you can claim the full 20% QBI deduction, the maximum effective rate for a pass-through entity will be reduced to 33.4%. That equals the highest federal income tax rate for individuals on passed-through income that is reduced to reflect the QBI deduction [37% x (100% – 20%)], plus 3.8% for the NIIT or 3.8% for the Medicare tax portion of the SE tax (whichever applies). Remember though, the QBI deduction is allowed only for 2018 through 2025, unless it is extended by Congress.
In this scenario, operating as a C corporation is probably preferred if the corporation is a QSBC. If QSBC status is unavailable, operating as a C corporation is still probably better — unless significant QBI deductions would be available at the owner level. If you expect to be eligible for the full 20% QBI deduction, pass-through entity status might be preferred. Discuss this issue with your tax advisor to understand all of the pros and cons.
Other Related Issues to Consider
Business owners can use many different strategies to help lower their tax bills, and those strategies may vary depending on the type of entity you decide on. Before finalizing the optimal business structure for your start-up, here are some other issues to consider.
Deductions for capital expenditures. For the next few years, C corporations and pass-through entities will be able to deduct 100% of the cost of many types of fixed assets. This is thanks to the TCJA’s generous Section 179 rules, which are permanent, and the 100% first-year bonus depreciation deduction, which is generally available for qualifying property placed in service between September 28, 2017, and December 31, 2022.
For a capital-intensive business, these changes under the new tax law may significantly reduce the federal income tax hit over the next few years. But lowering pass-through income with these favorable first-year depreciation rules will also reduce allowable QBI deductions.
Deductions for “reasonable” compensation. Historically, closely held C corporations have sought to avoid double taxation by paying shareholder-employees as much as possible in deductible salaries, bonuses and fringe benefits. However, salaries, bonuses and benefits must represent reasonable compensation for the work performed.
This strategy is a bit more attractive for 2018 through 2025 because the TCJA’s rate reductions for individual taxpayers means that most shareholder-employees will pay less tax on salaries and bonuses. Plus, any taxable income left in the corporation for tax years beginning in 2018 and beyond will be taxed at just 21%. Finally, C corporations can give shareholder-employees with some tax-free fringe benefits that aren’t available to pass-through entity owners.
S corporations have traditionally tried to do the reverse. That is, they’ve tried to minimize salaries paid to shareholder-employees to reduce Social Security and Medicare taxes. The IRS is aware of this tactic, so it’s essential to pay S corporation shareholder-employees reasonable salaries to avoid IRS challenges.
The TCJA does make this strategy more attractive for many businesses, because it maximizes the amount of S corporation income that’s potentially eligible for the QBI deduction. Guaranteed payments to partners (including LLC members treated as partners for tax purposes) and reasonable salaries paid to S corporation shareholder-employees do not count as QBI. But S corporation net income (after deducting salaries paid to shareholder-employees) does qualify as QBI.
Appreciating assets. If your business owns real estate, certain intangibles and other assets that may appreciate, it’s remains generally inadvisable to hold them in a C corporation. If the assets are eventually sold for substantial profits, it may not be possible to get the profits out of the corporation without double taxation.
In contrast, if appreciating assets are held by a pass-through entity, any gains on sale will be taxed only once at the owner level. The maximum rate will usually be 23.8% or 28.8% for real estate gains attributable to depreciation.
Spin-offs. A major advantage for pass-through entities is the QBI deduction. However the disallowance rule for service businesses may eradicate QBI deductions for some types of businesses, such as medical practices and law firms, that are set up as pass-through entities.
However, a spin-off may allow you to take a partial QBI deduction. How? If you can spin off operations that don’t involve the delivery of specified services into a separate pass-through entity, the income from the spin-off may qualify for the QBI deduction.
The IRS hasn’t yet issued guidance on this strategy. And since the QBI deduction is scheduled to expire after 2025 (unless Congress extends it), making big changes to create QBI deductions may not be worth the effort. Talk to your tax advisor before attempting a spin-off.
The TCJA has far-reaching effects on business taxpayers. Contact your tax advisor to discuss how your business should be set up on opening day to lower its tax bill over the long run.
For simplicity, this article focuses on start-ups. If you own an existing business and wonder whether your current business structure still makes sense, many of the same principles will apply. But the tax rules and expense for changing from one type of entity to another adds another layer of complexity. Discuss your concerns with a tax pro who can help you with the details of making a change.