The question of entity choice is again top of mind for many business owners, given the many changes that became effective January 1, 2018. With change comes a lot of questions and we’ve outlined several key points to explore. The answers to these questions will help your advisors make a thorough recommendation on the choice of entity for your current or future business.
Question 1: What’s your plan?
Do you have a strategic plan that includes expansion, acquisitions, or other major investments? Are there shareholders that will want to exit the business, requiring capital to repurchase their stock? Are you going to exit the business soon? If so, what is your plan?
As advisors, we need to understand your business plan, so we can apply the tax law to your plans. For example, if you are planning to grow or expand, you need to preserve capital. Given the new lower tax rate of 21% available to C Corporations, a C Corporation could make sense in that scenario. Many profitable pass-through entities distribute just enough cash to their owners to pay their taxes. For owners that are paying tax at the highest individual tax rate of 37% in 2018 for taxable income passed through to them from their business, a lower tax rate of 21% as a C Corporation, paid at the entity level, may be attractive given the 16% tax savings. This translates into additional capital in the business.
Long-term planning is difficult as change is inevitable, causing us to re-evaluate our strategic decisions, such as choice of entity. Thus, we recommend tax planning being limited to five years or less. Please note that many of the individual and business tax provisions change as the years pass and some are scheduled to expire on December 31, 2025.
Question 2: What is the new cost of “double taxation” given the new C Corporation rates?
Remember that pass-through entities allows owners to increase the basis in their investment which in turn will reduce the gain (or increase the loss) on a later sale of that investment. This is because the income is subject to individual tax when it is passed through to the owner.
An investment in C Corporation stock, however, does not accumulate basis. The corporation’s income is not passed through to its shareholders. The income tax is paid by the corporation – at the entity level. Thus, the original investment in C Corporation stock is generally the basis in that stock when it is sold, with limited exceptions.
Let’s look at an example.
Assume the C Corporation has $1,000 of taxable income. The income is taxed at 21%. After the tax of $210 is paid by the corporation, there is $790 of income left. Assume the entire $790 of income is paid out as a dividend to the shareholders. The shareholders pay tax at a 15% or 20% rate and could also be subject to an additional 3.8% Medicare surtax. If the shareholder is taxed at a 23.8% rate, the tax on this $790 dividend is $188. Thus, the combined corporate and individual tax is $398 ($210 + $188), or 39.8%. If the shareholder is instead taxed at a 15% rate and is not subject to the 3.8% surtax, the tax on this $790 dividend is $119. In this instance, the combined tax is $329 ($210 + $119) or 32.9%.
For pass-through entities, federal tax is paid at the individual owner level. The tax rate paid at the individual shareholder or partner level will depend on several factors including, the impact of the new 20% pass-through deduction from TCJA; other income, deductions, gains ; and the tax bracket of each shareholder or partner. Generally, the federal tax rate paid at an individual level could range from 20% to 37%.
So, the answer to the question on the impact of “double taxation” is: it depends. A comprehensive analysis by your advisor is needed.
Question 3: What will the effective tax rates be at the entity and individual level?
A key issue to decide on what the best entity choice will be revolves around understanding which expected tax rates you should be planning around. Once your advisor projects what they believe taxable income will be, they should apply a tax rate to that taxable income at both the entity and individual levels. Many of us advisors tend to plan that the business and individual will always be in the highest tax bracket. If that is not the case, this may change our decision as to the entity form. These are assumptions that need to be discussed and ironed out at the outset of the modeling process.
Consider a taxpayer, married filing jointly, who projects their 2019 taxable income to be $300,000, after considering all income and deductions. At this projected taxable income their marginal tax bracket is 24%. The highest individual tax bracket they could pay tax is 37%, but this applies with taxable income above $600,000. If this taxpayer is considering converting an S Corporation to a C Corporation based on the lower corporate tax rate of 21%, the federal tax rate difference in this case is a mere 3%.
Question 4: How does the new 20% pass-through deduction impact the choice of entity decision?
First, this new 20% pass-through deduction only applies to owners of pass-through entities and sole proprietors. It essentially reduces the tax rate for what is referred to as “Qualified Business Income” (“QBI”). For business owners, the 20% deduction is reported on their personal tax return after a complex computation.
This QBI deduction can reduce the top tax rate on this pass-through income from a max of 37% down to 29.6%. Thus, remember that the best scenario for a C Corporation, subject to tax at the entity level and a second tax on the dividend at the individual level, is 32.9%. Thus, for taxpayers who qualify for this new 20% deduction, the tax rate is generally lower for a pass-through entity.
Question 5: How will the new law impact the entity selection decision for start-up businesses?
Again, it depends. Here are three questions to address, all revolving around our best estimate of what will happen based on our plan:
- What do we project the taxable income or loss to be?
- Is this an active or passive investment, and will it qualify for the new QBI deduction?
- Do you expect losses for multiple years initially?
If a start-up business is going to generate losses that are expected to offset other taxable income to each of the owners, a pass-through entity would generally be favorable. The ability to deduct these losses is based on the owner’s investment as well as their level of participation. Again, careful analysis of each owner’s situation is necessary.
Another thought with a start-up is to explore the possibility of “Section 1202 stock.” This tax incentive is only available for C Corporations, but if the business meets these Section 1202 qualifications, it could result in significant tax benefits. If the stock is held for at least five years, then there is no taxable gain on the Section 1202 stock sale. This incentive is not available for pass-through businesses. Your Sikich advisor can help you navigate whether Section 1202 applies and make sense for your start-up business.
Finally, another consideration is if a start-up business is subject to the “hobby loss” rules. Many times, a start-up business formed as a pass-through reports a tax loss in its initial years of operation. The IRS could consider this to be a “hobby” instead of an actual business. If it is determined to be a “hobby,” the losses will not be deductible. A C Corporation might then be a preferable entity type as these losses can be preserved and carried forward each year until taxable income is generated to offset these accumulated losses.
Question 6: What about state tax compliance – how does this impact this decision?
The state tax rates should be considered. Some states tax pass-through entities as if they were a C Corporation, so the income taxes are the same. Some states do not tax pass-through entities consistent with U.S. tax treatment. Some states impose franchise or replacement taxes.
Once you have assessed the tax obligation at the state level, you should compare that to the state tax obligation at an individual level. Pass-through income will flow through to the state tax return for all owners and be taxed at the individual rate. C Corporations pay all federal and state tax at the entity level.
The tax rate difference for each entity type could be significant so this needs to be reviewed.
Secondly, the cost of compliance is another factor to consider. Pass-through entities that are required to file in multiple states can create compliance costs and burden to their owners. Each owner is required to pay tax on their apportioned share of income in each state the pass-through entity files. In many cases, the pass-through entity can file a composite return, effectively reporting income on the owners’ behalf, eliminating the filing requirement at the individual owner level. However, not all states allow this.
Lastly, remember that there were two other significant law changes related to state taxes in 2018. First, the Wayfair case was decided in the U.S. Supreme Court, effectively increasing the state filing requirements for entities. Prior to this decision, a physical presence was required for states to impose tax on an entity. The new standard is one of “economic nexus,” with each state establishing unique thresholds for this standard that entities must comply with. Economic nexus is based on sales activity and not physical presence. This applies to not only income tax but sales taxes as well.
The second law change for individuals, was that state and local income tax deduction is limited to $10,000 for 2018. Pass-through entity owners who have to report higher income due to their ownership, increasing their state income tax deduction, will lose some deduction. Conversely, state taxes reported by a C Corporation are deductible at the entity level and not subject to this limitation.
There are other factors that advisors would consider in recommending a choice of entity. These factors may come into play in your specific situation:
- Liability protection afforded in each entity type
- Succession planning
- Ability to raise capital
- Credits and loss carryforwards
- Governance considerations
- Upon exit, likelihood of a stock sale vs. an asset sale
- Business qualification under Section 1202
The choice of entity decision is one that requires careful review of all relevant facts and circumstances. There are no easy answers in 2018, but our Sikich advisers are available to help you run through any questions you have to make the 2018 tax season an easier process for you and other stakeholders.