This is the first of a series of blog posts on tax and compensation related issues. The principal goal of these posts is to assess where things stand on a variety of tax and business issues coming out of the 2017 tax reform process that culminated in the American Tax Cuts and Jobs Act of 2017 (TCJA).
A Starting Point
Perhaps this is obvious, but almost any form of entity is preferable for a variety of reasons (primarily, limitation on liability) to operating as an unincorporated sole proprietorship. If you prefer the simplicity of the sole proprietorship, in which the tax results of the business can be reported on the owner’s Form 1040 and no entity filings are needed, then use a 100% owned LLC treated as a “disregarded entity.”
Prior to enactment of the TCJA, the presumptive business entity form of choice was the LLC taxed as a partnership. The partnership form is extremely flexible and offers significant tax advantages over a regular taxable corporation (“C corporation”). In general, those tax advantages include:
There were two runners-up: (1) a subchapter S corporation (“S corporation”), which offers some of the same passthrough benefits as an LLC taxed as a partnership but with greater limitations; and (2) a C corporation, which is sometimes required by investors because it is the more traditional form and will be needed if the company is planning on going public.
Effects of TCJA
The 2017 Tax Act brought about a whole variety of major changes to the Federal tax system, ranging from major revisions to the international tax system to very significant changes to the estate and gift tax system. This blog post won’t attempt to summarize those changes or to provide a comprehensive discussion of the TCJA, although we plan to address other important changes in separate posts.
As relevant to the choice of entity debate, TCJA made the following changes:
Arguing for C Corporation Status
On first blush, the reduced tax rate for C corporations coupled with the elimination of the corporate AMT is an extremely attractive inducement to choosing C corporation status as the preferred form of business entity. The reduction in rate from 35% to 21% represents a 40% drop, and the elimination of the corporate AMT makes the deal seem that much better.
But reducing the effective rate on C corporation activities to 21% is, as a practical matter, easier said than done. For those of us in the real world, value must be transmitted from the corporation to its shareholders and employees in a liquid format to enable us to pay mortgages, buy food and the like. If C corporation revenues are paid out to employees as deductible compensation, the corporation will obtain a deduction at 21% and the individual will pay tax at a rate of as much as 37%. IF the amount is paid out as nondeductible dividends, the corporation is taxed at 21% and the shareholder at a rate of as much as 23.8%. Under either scenario, the 21% rate has evaporated.
The Elusive C Corporation Home Run
In an idealized world in which neither employees nor shareholders need cash, we could attain something like a 21% effective rate by having the C corporation re-invest its net income in operations of the company. In the context of a privately held company and under current law, at the death of the founding shareholders, heirs would receive a step-up in basis, thus eliminating the built-in gain in the business. The heirs could then sell the company for little or no taxable gain.
There are several problems with this approach. First, as mentioned above, employees and shareholders typically need or want cash during the life of the company. Second, as with the 20% deduction rules (discussed below), the IRS may argue (where all such net income is being reinvested) that compensation paid to employees is unreasonably low. Finally, the accumulated earnings tax (20%) may apply to retained earnings in excess of an exemption amount plus the reasonable needs of the business.
Other C or S Corporation Advantages
In addition to the preference that some private equity investors have for C corporations discussed above, two other C corporation advantages should be noted. First, certain kinds of employee benefits (notably, healthcare benefits but not retirement benefits such as 401(k) or pension plan participation) cannot be provided on a pre-tax basis in a partnership (an LLC generally elects to be taxed as a partnership), whereas C or S corporations can be more flexible. Also, a C corporation that meets a variety of technical requirements can be eligible for favorable tax treatment to shareholders if it qualifies as a “qualified small business” under Code section 1244. This benefit is subject to a number of restrictions but can result in the exclusion of up to 50% of the shareholder’s gain on sale.
Passthrough Business Deduction
TCJA has added a new incentive (Code section 199A) to operate a business in a passthrough form: the 20% deduction for qualifying business income (QBI). What this means is that for the owner of the business who receives QBI from a passthrough, the effective tax rate goes down from as much as 37% to 29.6%. This is another reason to prefer the passthrough structure. QBI does not include compensation income or investment income; in general, QBI is operating income from a business. Also, it’s also worth noting that over certain income thresholds, businesses such as professional services firms will not qualify for the 20% rate. We will explore this topic further in a separate blog post.
For most businesses, the tax revisions of TCJA will not warrant changing the form of business entity already selected. Unless the entity can reasonably aspire to the “home run” scenario outlined above, passthrough entities (most likely, an LLC taxed as a partnership) will continue to be the preferred form, especially if any of their business income can qualify for the 20% deduction. However, there are a number of reasons to prefer C or S corporations, so this is clearly not a case in which one size fits all.
If you have any questions or would like more information, please contact Joseph Ronan at email@example.com