The Tax Cuts and Jobs Act (TCJA) was signed into law by President Trump in late December 2017. Also known as Tax Reform, the TCJA has created quite a stir in the news then and it continues today. There’s no doubt the law made significant changes to both business and personal income taxes but for companies, one provision may have the most substantial long-term impact — the cut in the highest corporate tax rate from 35% to 21% and how it might influence entity selection.
For years now, the trend in entity selection has been toward partnerships and away from corporations; this is especially true for privately-held companies. For example, limited liability companies (LLCs), which generally have the option to elect corporate status or not, have, over the years, overwhelmingly preferred to be treated as partnerships for tax purposes. However, that trend may now be slowing or coming to a halt.
Subject to the type of business and the activity level of its owners, the corporate form of entity may now yield the highest tax savings for both owners and company. For example, if a business is considered “passive” to the owners, depending on the income level of the company and tax bracket of the owners, the difference in tax rates could be significant. Contingent upon the type of business, a pass-through entity, like a partnership, could yield federal income tax rates of more than 40% after the 3.8% net investment income tax. Compare that to the new highest federal corporate income tax rate of 21%, and it becomes clear why the trend toward partnerships may be over.
The law tries to make up for some of the difference in tax rates, such as a new 20% deduction for “qualified business income,” which reduces that amount of taxable pass through income. But not all business types qualify for this deduction and since the deduction is actually taken on an owner’s personal income tax return, this deduction is not a permanent change to the tax law. The sunset provisions added to individual income tax changes under Tax Reform mean that in 10 years this deduction could be gone.
These potential outcomes sound positive for corporations and their shareholders, but like most things related to the Internal Revenue Code, the devil is in the details. It’s important to remember the use of a C-corporation can still result in double-taxation. This typically happens when the corporation pays income tax on its earnings and then declares a dividend to shareholders, but dividends paid are not deductible to a corporation. The shareholder recognizes the dividends received as taxable income creating the double taxation. Of course, there are other ways to get money out of corporations, but a conventional return on investment in the form of a dividend will still result in double taxation. Since the level of dividends impacts how beneficial the C-corporation rates can be, planning before any change is essential. The result may still be advantageous over using a pass-through entity, but it needs to be evaluated before deciding to change.
Another consideration is the potential use of the Section 1202 exemption. Subject to eligibility, this provision of the law allows for preferential treatment on the sale of “qualified small business stock.” The result could be the exclusion of 100% of the gain on the sale of the stock. This is another situation that requires substantial planning to ensure that all the requirements are met and could be another reason to consider a switch to the C-corporation form of entity.
Entity selection under Tax Reform is a crucial element to address. Depending on circumstances and the type of business, a change in entity could yield tangible tax savings over the long haul. Whether your company makes a change or not, any decision should involve a detailed modeling and analysis process to determine the best choice for your business. A discussion about how the change might impact other aspects of your business is also vital. No change is easy, so be sure you’ve done your homework and you are comfortable with all aspects of the change before making the switch.
David Thaw is Shareholder and Tax Practice Group Leader with Gumbiner Savett. For more information, visit www.gscpa.com
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