Happy man in business suit
New tax laws make choosing the right business entity a little trickier. — Getty Images/gradyreese

Newly enacted tax legislation may be the most impactful since the Tax Reform Act of 1986 – affecting both corporate and pass-through entities alike. The substantial reduction in the corporate tax rate has left many pass-through entities questioning whether a conversion to corporation status might make sense.

However, such a change is not as simple as comparing tax rates. Instead, the decision can also be affected by the financial structure of the business, its capital needs now and in the future, whether it will retains its earnings or distributes them regularly, and the growth potential and possible exit strategies of partners or owners.

C corporations vs. Pass-through entities

The tax differences between C corporations and pass-through entities are significant, but they generally revolve around the fact that C corporation earnings are subject to double taxation – first at the corporate level, and then again at the shareholder level when earnings are distributed to the owners.

Earnings of pass-through entities, on the other hand, are generally only taxed once – at the individual level. This difference is one of the main considerations in selecting the most tax efficient structure for a business.

The new tax law has significantly impacted this analysis, causing many to consider whether their current structure – whether it be pass-through or C corporation – is the most efficient.

Specifically, with the enactment of the new tax law, the earnings of a C corporation are now taxed at a flat 21% tax rate, with shareholders still paying the second layer of tax due when the earnings are distributed. Pass-throughs also experienced a tax cut as a consequence of the reduction in individual income tax rates and the enactment of a new deduction for certain qualified business income. The highest marginal tax rate applied to the owner of a pass-through entity was reduced from 39.6% to 37%. In addition, certain eligible pass-through entities can take a 20% deduction against those earnings, thereby reducing the overall tax rate on a pass-through entity's earnings to an effective 29.6% rate.

To see the impact of these changes, consider the case of a business that generates $100 of income, which it distributes to its business owner who is in the top marginal tax bracket:

C corporation: The company first pays corporate level tax of $21 on the $100 of income, leaving $79 available to be distributed to the shareholder. The shareholder then pays tax at a 23.8% rate (including the net investment income tax) on the distribution (tax of $18.80), which leaves $60.20 in the shareholder’s hands. This translates into an effective tax rate of 39.8%.

S Corporation that doesn’t qualify for the 20% deduction: There is no corporate level tax; instead the shareholder pays tax on the income at his marginal tax rate. So he pays $37 in taxes, leaving $63 for the shareholder. This translates into an effective tax rate of 37%.

S Corporation that qualifies for the new 20% deduction: The $100 of income is again taxed the shareholder level, but the shareholder is able to take a 20% deduction. So the shareholder is taxed on $80 at the 37% marginal rate. Total tax is $29.60. This results in an effective tax rate of 29.6%, with the owner retaining $70.40 after federal tax payments.

Understanding business entities

While tax rates and after tax cash are a major factor in entity choice, there are other differences between entities as well, such as the ability of C corporations to have an unlimited number of shareholders, to have foreign shareholders, issue more than a single class of stock, make public offerings, own other corporations, and deduct fringe benefits provided to shareholder employees.

In addition, individuals who inherit shares of C corporation stock can escape significant capital gains taxes when they receive a step-up in basis to fair market value upon inheriting stock. On the other hand, owners of pass-through entities are able to deduct business losses on their individual tax returns (subject to certain limitations) against other income the shareholder may have, an advantage not available to C corporation owners.

Another consideration with respect to choice of entity is the change in the deductibility of business interest. Previously, interest paid by a business was completely deductible, in the same way that interest income to a business was fully taxable. Now, the law imposes a limitation on deductions for business interest incurred by certain large businesses—defined as any business, regardless of structure—except for (1) those with average annual gross receipts of $25 million or less, (2) real estate and farming businesses that elect to exempt themselves, and (3) certain regulated utilities. For businesses subject to this new interest limitation, deductible business interest expense is now generally limited to 30% of the business’s adjusted taxable income.

This means businesses that are debt-financed will face a very different tax situation than in the past when interest was fully deductible. This might influence a business that expects to borrow large amounts and cause them to consider structuring as a C corporation in order to raise capital through stock offerings rather than debt. Previously, the tax incentive for businesses favored debt over equity, especially since distributions of earnings aren’t deductible to the business. These changes level the playing field slightly.

Other consideration

Another issue to consider is whether the company has sufficient cash on hand to distribute any previously-taxed income of the S corporation during the post-termination transition period – typically a one year period following the date of conversion. If the previous tax earnings are not distributed within this period, it becomes more difficult to get those amounts out on a tax-free basis.

Business owners will want to consult their tax advisers on these and other details of the new tax act. Questions include:

  • Will changing my corporate structure lower my overall tax obligation?
  • Should we make changes now or later?
  • How will another structure affect my exit strategy?
  • How does my debt to equity mix affect the analysis?

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

Published February 25, 2019