In late December 2017, the congress passed the Tax Cuts and Jobs Act (TCJA) which introduced a flat 21% federal income tax rate for C corporations for tax years beginning in 2018 and beyond. Prior to the TCJA, C corporations that generated a profit paid as much as 35% of that profit over to the federal government in the form of an income tax. With a shiny new 21% rate, many business owners are now asking: What’s the optimal choice of entity for my start-up or existing business?
In the beginning . . . there is a choice as to tax/business structure
Prior to the TCJA, conventional wisdom was that most small and midsize businesses should be set up under the broad group of incorporated entities called “pass-through entities” that included:
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- Single-member limited liability companies (LLCs) treated as sole proprietorships for tax purposes (sometimes referred to as a “disregarded entity for tax purposes”);
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- Partnerships (with some sort of limited liability filing);
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- LLCs treated as partnerships for tax purposes, and
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- S corporations.
The big reason that pass-through entities have been popular is that technically income from C corporations is taxed twice. First, the C corporation pays entity-level income tax (to the extent there are profits). And then, shareholders pay tax on dividends and on capital gains received when the shares are sold. Pass-through entities avoid double taxation C corporation because there is no federal income tax at the entity level. Historically, the perception (and maybe the reality) has been that pass-through entities reduce the overall tax burden on a business enterprise.
But along comes the TCJA to throw a curve ball into this historical belief. While C corporations are still subject to double taxation, under the TCJA the new 21% corporate federal income tax rate reduces the perceived tax disparity between C corporations and pass-through entities.
But wait, the TCLA is not done mixing up the playing field. Enter the QBI. The TCLA allows noncorporate owners of pass-through entities to take a deduction of up to 20% on qualified business income (QBI).
What is the QBI Deduction for Pass-Through Businesses?
For tax years beginning after December 31, 2017, the TCLA establishes a new deduction based on a noncorporate owner’s share of a pass-through entity’s qualified business income (QBI). This deduction is available to eligible individuals, estates and trusts. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.
While the QBI deduction is disallowed for the calculation of a noncorporate owner’s adjusted gross income (AGI), it does reduce taxable income much like an allowable itemized deduction.
The QBI deduction generally cannot exceed the greater of the noncorporate owner’s share of:
- 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year, or
- the sum of 25% of W-2 wages plus 2.5% of the cost of qualified property (to allow capital-intensive businesses to claim meaningful QBI deductions). “Qualified property” means depreciable tangible property (including real estate) owned by a qualified business as of the tax year end and used by the business at any point during the tax year for the production of QBI.
The W-2 wage/qualified property limitation does not apply until a noncorporate owner’s taxable income exceeds $157,500, or $315,000 for a married individual who files jointly. Above those income levels, the W-2 wage/qualified property limitation is phased in starting at $50,000 taxable income for an individual or starting at $100,000 for married individuals who file jointly.
QBIs are not available for certain specified service businesses, such as most professional practices. Under an exception, however, the service business disallowance rule does not apply until an individual owner’s taxable income exceeds $157,500, or $315,000 for a married individual who files jointly. Above those income levels, the service business disallowance rule is phased in starting at $50,000 taxable income for an individual or starting at $100,000 for married individuals who file jointly.
So, with new rates and the QBI in mind, what is the right answer?
Unfortunately, there is still no 100% right answer about which tax type to choose when deciding how to structure your business to minimize taxes. The answer depends on each business’s unique situation and the situation of its owners.
Below are a couple of entity selection options for start-up ventures:
Losses
If your business consistently generates losses (which is typical for start-up ventures), a C corporation does not make a lot of sense, losses generated by a C corporation cannot be deducted by its owners. So, if there are losses (and the ownership class can use those losses) it probably makes sense to operate as a pass-through entity because the losses will pass through on each owner’s personal tax return (on Schedule C, E, or F, depending on the type of entity you choose).
Profitable Business with all profits distributed to Owners
Disregarding losses, if a business is profitable and distributes all of its profits out to its owners (let’s disregard retained earnings) the implications of operating as a C corporation vs. a pass-through entity look like this:
C corporation. After paying the flat 21% federal income tax rate at the corporate level, the corporation pays out all of its after-tax profits to its shareholders as taxable dividends eligible for the 20% maximum federal rate.
Under these circumstances, the maximum combined effective federal income tax rate on the business’s profits (don’t forget the 3.8% net investment income tax (NIIT) on dividends received by shareholders) is 39.8%. This equals 21% for the corporate level tax, plus the personal level tax rate on the dividends, which is reduced by the corporate level tax [(20% + 3.8%) x (100% – 20%)]. While you would still have double taxation here, the 39.8% marginal rate is lower than it would have been under prior law.
Pass through entity. For a pass-through entity that pays out all of its profits to its owners, the maximum effective federal income tax rate on the business’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). If we assume 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 an individual owner can claim the full 20% QBI deduction, the maximum federal income tax rate is reduced to 33.4%. That equals 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).
So, based purely on tax rate, operating as a pass-through entity is probably the way to go if significant QBI deductions are available. If, however, QBI deductions are not available, it’s a toss-up and operating as a C corporation may be simpler from a tax perspective.
Business Retains All Profits to Finance Growth
If a business is profitable, but it retains all of its profits to fund future growth strategies, the implications of operating as a C corporation vs. a pass-through entity look like this:
C corporation. If no dividends are ever made and the retained profits increase the value of the corporation’s stock dollar-for-dollar, and then the shareholders eventually sell their shares, they will pay federal income tax at the maximum of the 20% rate for long-term capital gains.
In this scenario, the maximum effective combined federal income tax rate on the business’s profits is 39.8%. That equals 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%)]. While you would still have double taxation here, the 39.8% rate is better than it would have been under prior law. Plus, shareholder-level tax on the stock sale gains is deferred until the stock is sold.
Pass-through entity. Under similar assumptions for a pass-through entity, the maximum effective federal income tax rate on the business’s profits is 40.8%. This calculation is the same as above in the distribution scenario. For a pass-through entity, however, there is a key difference — all taxes are due in the year that income is reported. With a C corporation, the shareholder-level tax on the gain on the stock is deferred until the shares are sold.
If, however, an owner can claim the full 20% QBI deduction, the maximum effective rate for a pass-through entity is reduced to 33.4%. This calculation is the same as above in the distribution scenario.
Additional Changes that might impact decisions
Business owners can use a variety of strategies to help lower their tax bills, and those strategies may vary depending on the type of entity you choose. Before deciding on the optimal business structure for your business, here are some other items to consider.
Capital expenditures deductions. For the foreseeable future, both C corporations and pass-through entities will be able to deduct 100% of the cost of many types of fixed assets. They can also take advantage of 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.
These changes may significantly minimize the federal income tax on a capital-intensive business over the next few years. For pass-through entities, however, reducing pass-through income with these favorable first-year depreciation rules will also reduce allowable QBI deductions for owners.
Reasonable compensation deductions. Closely held C corporations have historically sought to avoid double taxation by paying shareholder-employees as much as possible in deductible salaries, bonuses and fringe benefits. Despite this goal, salaries, bonuses and benefits still must represent reasonable compensation for the work performed.
Under the TCJA, ror 2018 through 2025, this strategy is a bit more attractive because the rate reductions for individual taxpayers mean that most shareholder-employees will pay less tax on salaries and bonuses. And, any taxable income left in the C corporation for tax years beginning in 2018 and beyond will be taxed at only 21%. Finally, C corporations can provide shareholder-employees with some tax-free fringe benefits that are not available to pass-through entity owners.
Historically, owner – employees of S corporations have tried to do the opposite; owners have attempted to minimize salaries paid to shareholder-employees to reduce Social Security and Medicare taxes. The IRS understands this game, so it is still important to pay S corporation shareholder-employees reasonable salaries to avoid IRS issues. But the QBI deduction strikes again! The TCJA, however, makes this strategy even more attractive for many businesses, because the TCJA maximizes the amount of S corporation income 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. When it comes to real estate, as well as certain intangibles and other assets that are likely to appreciate, it still generally advisable to hold those assets in a pass-through entity (an LLC or partnership) and not in a C corporation. Why? If the assets are eventually sold for substantial profits, it may be impossible to get the profits out of the C corporation without double taxation.
In contrast, if appreciating assets are held by a pass-through entity, gains on sale will be taxed only once at the owner level. The maximum rate will generally be 23.8% or 28.8% for real estate gains attributable to depreciation.
