Tax reform has caused business owners to reconsider their entity structure. Consider these points before changing yours.
Tax reform reduced the highest corporate federal income tax rate from 35 percent to 21 percent and provided a new 20 percent deduction on partnership and S corporation income, leading many pass-through entities to reevaluate their structure to achieve greater tax savings. While C corporation status may be relatively more attractive following tax reform, there is no one-size-fits-all solution.
Like other aspects of business planning, entity structure planning occurs in an environment of uncertainty.
To help determine whether you should switch from an S corporation to a C corporation, ask yourself the following five questions: What is the effective tax rate on business income? It’s tempting to compare the top marginal federal income tax rates of a C corporation (21 percent) with the top rate of a pass-https://ingrams.com/wp-admin/themes.phpthrough entity (somewhere between 29.6 percent and 40.8 percent) and conclude that a C corporation is better. Personal tax rates vary depending on your income, so you should compare the effective tax rate rather than the top marginal tax rate.
If your taxable income (without business income) is less than $500,000 ($600,000 for joint tax returns), the effective tax rate on your business income will be lower than the top marginal rates. Example: A married couple has $190,000 of wages, $435,000 of business income, and no other items or income, deduction, or credit. The effective tax rate on the couple’s business income is 23.6 percent if the business is an S corporation eligible for the 20 percent business income deduction and 21 percent as a C corporation (compared to marginal tax rates of 28 percent as a pass-through and 21 percent as a C corporation).
In some instances, the effective rate on pass-through income will be lower than the corporate tax rate of 21 percent. What will rates be in the future? The reduced individual rates expire after 2025 while the 21 percent corporate income tax rate does not expire. However, it is possible that Congress could tweak the corporate tax rate or extend individual tax cuts in the future. Since nobody has a crystal ball, consider the effect of possible tax rate changes on your entity decision.
It is easier to convert to C corporation status than from C corporation status, so pass-through entities provide more flexibility to respond to tax rate changes than a C corporation. What are the plans for owner distributions? Some bus-inesses will have a lower effective tax rate as a C corporation than as a pass-through entity but they need to consider the second level of tax that applies when earnings are distributed. If corporate earnings are distributed (rather than retained), the effective tax rate is actually 39.8 per-cent, which may be higher than the rate applicable to pass-through earnings.
If you plan to distribute corporate earnings, you may be better off with a pass-through entity. If you will rein-vest earnings in the business for a significant number of years—defer-ring the shareholder tax imposed on corporate dividends—you may be bet-ter off with a C corporation.
Will the accumulated earnings tax apply? If a C corporation retains earnings beyond its reasonable business needs, the IRS can impose a 20 percent tax on excess accumulated earnings. The tax has been assessed accumulating earnings in the corporation. This may change in res-ponse to the new lower tax rates. The tax is a third tax on corporate earnings and does not apply to pass-through entities.
If the tax would apply, the corporation might be bet-ter off as a pass-through entity or distributing earnings. How and when do the owners plan to transition the business? As part of entity structure planning, you will want to consider the impact the structure will have on the after-tax cash flow from an eventual business sale. After-tax cash flow from the sale of a pass-through entity is generally higher than from the sale of a C corporation.
In some instances the gain from the sale of C corporation stock may be exempt from tax, so an analysis of your particular circumstances is necessary to evaluate the pros and cons of different structures for your business. Like other aspects of business plan-ning, entity structure planning occurs in an environment of uncertainty.
While only time will tell whether the selected tax structure for a business was the best one, careful planning and consideration of the questions above will improve the odds of selecting a structure that meets your needs.