The Rush to C Corporation that Wasn’t
In the months leading up to and immediately following the enactment of the Tax Reform bill, there was a lot of speculation in the tax community that there would be an increase in the number of businesses electing to be taxed as C corporations to take advantage of the new 21% corporate tax rate. So what have we seen? The choice of entity discussion really hasn’t changed significantly as a result of Tax Reform. Yes, the corporate rate was reduced, but for pass-through entity owners who qualify for the new qualified business income deduction, the rate reduction isn’t as significant as it appeared at first blush.
It really becomes a business plan discussion. If a business owner intends to keep all the profits of the entity inside the entity and make no distributions or dividends, then being taxed as a C corporation is attractive, especially if that owner ultimately intends to exit or retire via a stock sale. In this case, the effective federal tax rate on the business’s profits is a maximum of 21%.
If instead that business owner, after choosing to be taxed as a C corporation, changes his/her mind and decides to start making distributions of profits, the effective tax rate on the profits increases to a maximum of 39.8% as a result of the personal income tax on dividends when the profits are distributed.
In the alternative, if that business owner determines that it makes more sense to maintain flexibility to withdraw profits and elects to be taxed as an S corporation or other pass-through entity and critically, if that business owner qualifies for the qualified business income deduction under Section 199A of the Code (watch for a future blog on this subject), the effective federal tax rate on the business’s profits is a maximum of 29.6%.
If the business owner fails to qualify for the deduction under Section 199A, the tax rate on the profits is a maximum of 37%.
When the business owner makes a distribution of profits from the pass-through entity, those profits may be distributed tax-free.
For existing businesses, making an election to be taxed as a C corporation may come with a tax cost as a result of the deemed dissolution of a partnership.
Once the election to be taxed as a C corporation is made, any decision to return to partnership or disregarded entity status, will come with a tax cost. An election to be taxed as an S corporation may not currently have a cost but may if the assets of that S corporation are sold within 5 years.
While C corporations are certainly more attractive than they have been in the future, we have not seen a rush to convert. As previously was the case, choice of entity should be made on a holistic basis, with each business owner making a careful examination of their current and future plans.
Stay tuned for our discussion of the qualified business income deduction under Section 199A of the Code in the coming weeks.