One of the more heavily publicized effects of the Tax Cuts and Jobs Act of 2017 (the “Act”) was to change the tax rates and rules for subchapter C corporations. This has led many entrepreneurs to ask whether they should form their businesses as C corporations, and has caused many existing business owners to question whether they should convert their businesses into C corporations.
Unfortunately, the Act also made those questions more difficult to answer. C corporations and pass-through entities (the other major category of business entities, including limited liability companies and subchapter S corporations) are treated very differently under the Act. The Act retains the general concept that C corporation earnings are subject to taxation both at the company level and again at the individual level when the company issues dividends (often referred to as double taxation). It also retains the general concept that earnings of pass-through entities are taxed only once, when those earnings are distributed, or “passed through,” to the owners. However, the Act’s provisions applicable to C corporations are very different from those applicable to pass-through entities and the treatment of pass-through entities now varies widely depending on the business’s specific industry and its owners’ income levels, among other factors.
While tax implications are an important part of the decision about business type, there are other important factors to consider, and those other considerations were not affected at all by the Act. Still, given all the considerations that have changed, it is important for business owners and entrepreneurs to discuss their individual situations with their legal and financial advisors before choosing an entity type.
What hasn’t changed
Some primary reasons business owners and entrepreneurs form C corporations and pass-through entities – as opposed to operating businesses as sole proprietorships – are to gain liability protection, to allow the business to endure after the founder ceases to be involved in its operation and to facilitate pooling resources from investors. None of these considerations were changed by the Act.
- Both pass-through entities and C corporations provide financial liability protection to their owners, and both can have perpetual existence
- Both C corporations and pass-through entities work well for pooling resources, although certain entity types work better than others for certain purposes. For example, publicly trading equity in LLCs is difficult, so entrepreneurs who intend to make public offerings of their businesses’ equity typically choose C corporations.
- Another consideration is ease of operation. LLCs are exempt from many of the strict procedural rules that apply to S corporations and C corporations, which makes LLCs more attractive for small, closely held businesses.
What has changed
Before the Act, estimating whether net taxes would be lower for an owner of a C corporation or a pass-through entity was a relatively simple matter, with pass-through distributions taxed at individual income tax rates and C corporation earnings taxed at progressive rates at the corporation level, and the portion of those earnings issued as dividends taxed again at progressive rates when received by the shareholders.
In place of the graduated rates previously applicable to C corporations, the Act reduced taxes on C corporation income to a flat rate of 21%. Dividends are still taxable when received by the shareholders.
Since income is not recognized at the company level for pass-through entities, Congress could not include a similar tax cut for pass-through entities. Instead, they provided that if a business owner receives “Qualified Business Income” (“QBI”) from a pass-through entity, that business owner can deduct from his or her taxable income the lesser of 20% of his or her taxable income (less net capital gain), or the amount of the QBI. Determining whether income is QBI requires consideration of multiple factors.
In an attempt to prevent taxpayers from abusing the deduction, Congress further complicated the system by adding that if an individual’s QBI comes from entities in certain categories of business and the individual’s income exceeds a certain threshold, the taxpayer is not eligible for the 20% deduction. The categories of businesses for which the deduction is restricted are generally service businesses (such as healthcare practices, accounting firms and law firms). Deductions for owners of these types of businesses begin to phase out at an income level of $157,500 for individuals ($315,000 for joint filers), and are fully eliminated at $207,500 for individuals ($415,000 for joint filers).
Additionally, for pass-through entity owners with income above the thresholds set forth above, the amount of the deduction is further limited based on formulas tied to the amount of W-2 wages that the taxpayer receives from the business, regardless of whether the business is in one of the specified categories for which the deduction is otherwise restricted.
In light of the new tax law, many factors must be considered when figuring out which entity type produces the most favorable tax results. Those factors include, but are by no means limited to:
- The type of products or services to be offered by the business
- The ability, and desire, of owners to leave funds in the business
- The taxable income of the owners
- The wages to be paid by the business
- The portion of the business’s income which will be paid to owners in the form of salary or wages as opposed to as dividends or distributions
- The anticipated lifespan of the business
Again, the Act has made analyzing the tax implications of entity choice extremely complicated, and individualized advice from legal and financial advisors is necessary to properly analyze such implications.
The non-tax considerations related to whether a business should be a C corporation or a pass-through entity were not changed by the Act. For some owners and entrepreneurs, those considerations will be the primary factors for deciding which type of entity to use. However, all owners and entrepreneurs should still consider the tax implications of their choice of entity; and for some owners and entrepreneurs, the tax implications will be determinative. Analyzing those tax implications has been made much more complicated by the Act, and requires discussions with both legal and financial counsel. Please contact us if you would like to discuss what type of entity is right for your business.
About the Author
Eric R. Benson is a business law attorney with Ireland Stapleton Pryor & Pascoe, PC. His practice focuses on advising businesses on legal matters throughout the life cycle of the business. He also advises nonprofit organizations regarding formation, qualification for tax exempt status, mergers and acquisitions, and general matters related to their operations. Contact Eric directly at 303-628-3615 or firstname.lastname@example.org.
What is written here is intended as general information, and is not to be construed as legal advice. If legal advice is needed, you should consult an attorney.