The 2017 Tax Cuts and Jobs Act enacted major changes to the US tax system, including broad reductions in corporate income tax rates, a 20% deduction for qualified business income earned by pass-through entities, and modest reductions in individual income tax rates.
This article briefly summarizes how the Tax Act might impact the choice of legal entity for new and existing businesses.
As an initial matter, for high growth startups on the venture path, the Tax Act is unlikely to impact the prevailing preference for C-corps, for reasons nicely summarized by Gust:
- The tax rate has been lowered for C corps and startups generally don’t pay dividends. Most startups put every dollar they make into the business to grow and scale their business. The corporation will now pay less in taxes on any income they make, and startups that are C corps already don’t pay dividends, so there are still no double taxation concerns to worry about.
- The qualified small business stock (QSBS) under § 1202 still only applies to C corps. This exemption says that stock owners in qualified C-Corporations can exclude $10 million or 10x aggregate adjusted basis (higher of the two) at the successful exit of the business.
- Venture capitalists have not done anything to suggest that they will no longer prefer to invest only in Delaware C-Corps. VCs still want to limit the legal and regulatory complexity of their portfolios. Because of this, it is unlikely that their preference to invest only in Delaware C-Corps will change with the new tax laws.
For businesses not fitting the venture profile, the choice-of-entity issues raised by the Tax Act require a multi-faceted analysis, ideally in partnership with your accounting and tax advisors. Following summarizes several factors that will play into the analysis of whether c-corp or pass through taxation will improve your results:
1. Tax Rate. C corp income is now taxed at a flat 21% rate whereas pass-through income flowing through to an individual partner is subject to tax at a maximum 37% rate. In addition, C corps can fully deduct state and local taxes whereas an individual’s deduction is limited to a maximum of $10,000.
2. Limitations on Availability of Pass-through Deduction. Pass-through income may be eligible for a 20% deduction for qualified business income (QBI), but the deduction is not allowed for most service businesses (unless taxable income is less than $415,000 ($207,500 if not married filing jointly) and is subject to other limitations. An analysis will be required to determine the extent to which your business will benefit from the new pass-through rules in comparison with reductions in corporate tax rates and other benefits.
3. C-Corp Dividends Remain Subject to Double Tax. If a business does not make distributions to its owners (for example, the owners generally take only salary and perks and profits are reinvested), then a c corp structure may result in income tax savings. On the other hand, if the business distributes all of its profit out to its owners annually, then the double tax resulting from a C corp structure will be disadvantageous.
4. Tax On Accumulated Cash. C Corps may be subject to accumulated earnings tax and personal holding company tax for cash accumulated in the business.
5. Taxation Upon Sale of Company. Sale of c-corporation assets may be subject to double-taxation. Care should be taken to consider owners' exit strategies and whether assets may be held individually to avoid double tax.
6. Step-Up at Death. If an owner dies owning C corp stock, the stock will receive a step-up in basis to its fair market value. This will avoid a shareholder level tax if the C corp liquidates. However, it does not avoid a tax to the corporation on any appreciated assets that are distributed in liquidation or later sold by the C corp.
7. Deductibility of Losses. If a partnership has losses that flow through to its partners, those losses would not flow through if the entity becomes a C corp, so C corp status would be disadvantageous.
8. Timing. Changes in the tax elections are subject to a variety of complex rules and deadlines. For example, s corps terminating their s-election are subject to a five year waiting period to convert back to S status. Converting a c-corp to S corp may result in recognition of taxable gain.
In short, business owners should run the numbers with their financial and legal advisors to determine if new tax laws warrant changes in the choice of entity.