By Liang Zhao, CPA, MSA, CMA, Senior Accountant
Before the passage of the Tax Cuts and Jobs Act, pass-through entities, such as S Corporations and limited liability companies (LLCs) taxed as partnerships, had been the most popular entity choices among small business owners. In comparison, C corporations had been less appealing due to high tax rates and a possible double-taxation feature.
However, the new tax law has replaced the tiered C corporations tax rates, which had a maximum rate of 35%, with a flat tax rate of 21%. Due to this dramatic change, more and more business owners are wondering if converting their businesses to a C corporation makes sense from a tax perspective.
Below are some of the factors you should consider when re-evaluating your business structure under the new tax law.
- Being a C corporation could be beneficial for business owners who are not eligible for the 20% qualified business income deduction (QBID) and their businesses will not be subject to the personal holding company (PHC) classification. Under the new tax law, certain business owners may deduct up to 20% of qualified business income earned through pass-through entities. However, the 20% deduction may, depending on the personal income levels of the pass-through owner, be subject to phase out limitations if the business is a specified service business. Specified service businesses include but are not limited to accounting, health care, law, brokerage and certain consulting services. As the 20% QBID deduction is one of, if not the most complicated area of the new tax law, we encourage discussing whether the QBID applies to your business with a tax professional. Read more about QBID here.
- For C corporations, taxes are levied on taxable income as well as on dividends distributed to shareholders. Therefore, the less distributions you plan to take out of your business, the more beneficial a C corporation might be for you.
- For current pass-through entity owners, the effective tax rate of your business income taxed on your individual return should be more than 21% for you to benefit from the new C corporation flat tax rate. Using the 2018 tax rates, the 21% effective tax rate for a married-filing-jointly taxpayer occurs around $335,000 of taxable income and around $167,000 of taxable income for single taxpayers. The higher your business’ taxable income is, the more tax savings you may enjoy by choosing C corporation.
- If your business usually generates significant losses, you may want to consider the different treatments between being a C corporation and a pass-through entity. In the past, pass-through entity owners were able to deduct losses without limitations if they passed the basis, at-risk, and passive-activity tests. Under the excess business loss provision of the new tax law, non-corporate taxpayers are limited to offset a maximum of $250,000 ($500,000 for joint filers) of income with losses from a pass-through entity in the current tax year. There is no such excess business loss limitation posed on C corporation taxpayers. In general, C corporations can deduct losses up to the extent of their taxable income and can carry the excess losses, as a net operating loss (NOL), to other tax years.
- Don’t forget non-financial factors. In additional to minimizing current tax liabilities, it is important that business owners take other factors into considerations when evaluating entity forms. Do you want to hold the business for as long as you can? Do you already have an exit strategy? Do you plan to give ownership to your employees? Do you have international exposure? Should you consider setting up another business entity to take advantage of the benefits of both pass-through entities and C corporations under the new tax law?
Although the list above is a good place to start for re-evaluating your business structure, there is so much more to consider when it comes to choosing entity formation. It is always a case-by-case determination. Therefore, detailed long-term tax planning on both the business and your individual tax levels is always highly recommended.
