The Effects of Tax Reform: Time to Incorporate?
June 5, 2019
Every new business has to face the same question: what kind of legal entity should be formed? This issue, commonly known as “choice of entity”, can be particularly thorny for two reasons: it has to be resolved very early in the process of starting a new business, and it can have lasting ramifications for the operations, governance and financials of the business.
Typically, business owners select either C corporation, partnership, limited liability company or S corporation. Tax considerations drive a major portion of this decision. Often, the choice for business owners comes down to whether a C corporation, and the “double tax” involved in getting cash out, is worth it for non-tax reasons, versus an S corporation, LLC or partnership (colloquially known as “flow-throughs”), upon which a single level of tax is imposed. In recent history, many business owners have opted for the latter. After all, when it comes to tax, one level seems better than two.
Recently, tax reform has changed some of the facts underlying the old assumptions, and new as well as existing businesses would be well served by examining the pros and cons of each option before committing to a particular form, or deciding to convert. The Tax Cuts and Jobs Act (TCJA) made many changes. Below we highlight two significant changes that will influence whether to operate as a corporation or a flow-through.
Lowering of the top corporate tax rate from 35% to 21%
This single change makes operating in corporate form significantly more attractive than it had been. At the corporate level, the rate was reduced by 14 percentage points. At the shareholder level, the taxation of dividends remained the same, with a top rate of 20% plus a 3.8% net investment income tax, for a combined tax rate on corporate profits of about 39.8% on the distribution of corporate earnings as cash to shareholders.
However, earnings that are not distributed are subject to only one level of tax. For some companies, depending on their plan for reinvestment or paying dividends, a C corporation may be significantly more tax-efficient.
Consider a new business, where the owners decide to prioritize the growth of the company and plan to reinvest all available profits for several years. In a corporation, those profits are subject to tax at 21% at the corporate level, but there is no second level of tax imposed, because the profits are not being distributed to shareholders. In this situation, $79 of every $100 of profit could be available for reinvestment.
Contrast this with a flow-through structure like an LLC or S corporation. Profits allocable to each equityholder are generally taxed at the rate applicable to the equityholder. For an individual, that can be 37% (though the TCJA also introduced a special deduction for certain businesses operated as LLCs or S corporations, that can bring the top marginal tax rate down to 29.6% – see below). This is the generally applicable federal income tax rate whether the profits are distributed or not. It is common for flow-through entities to make distributions to cover the taxes of the equityholders, making such distributions unavailable to be reinvested. In this scenario, $63.00 to $70.40 of every $100 of profit could be available for reinvestment – in each case, less than with a corporation.
Over time, the additional retained and reinvested profits can allow a corporation to grow significantly faster than the same business operated in LLC/S corporation form. And, at the time of exit, such transactions can usually be structured tax-efficiently, such that only one level of tax applies.
20% deduction on certain income of flow-through entities
For businesses considering a flow-through structure, such as a partnership, LLC, or S corporation, consideration should be given as to whether the deduction under Section 199A of the Internal Revenue Code is applicable.
The 199A deduction is generally equal to 20 percent of “qualified business income” (“QBI”) from flow-throughs such as LLCs and S corporations. If fully applicable, this deduction lowers the top effective tax rate from 37% (plus a potential 3.8% net investment income tax) to 29.6% (plus the potential 3.8%). However, the availability of the deduction is subject to certain limitations based on the type of business, income thresholds, wages paid and invested capital.
If the taxpayer’s income is above a certain threshold ($415,000 if filing a joint return), then businesses the taxpayer owns in certain industries (“specified service trades or businesses,” in the language of the rules) are generally ineligible for the deduction. If the business is not a specified service trade or business, then the deduction is available, but subject to certain limitations based on W-2 wages paid and invested capital.
What are specified service trades or businesses? They include any trade or business engaged in the performance of services in a litany of fields: law, health, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more of its employees, or that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests or commodities.
However, if the income of the taxpayer is below a certain threshold ($315,000 if filing a joint return), then the 199A deduction is generally available, without regard to the type of business, W-2 wages paid or invested capital. To further complicate matters, if the income of the taxpayer is above the lower threshold, but lower than the higher threshold, then the various limitations (wage, invested capital and specified service trade or business) are phased in.
The 199A deduction can result in more tax savings compared to operating in corporate form. However, for business owners trying to make a decision about choice of entity, the analysis also adds a layer of complexity and uncertainty.
While important, there are many considerations beyond the highest effective tax rate that can be relevant in choosing the form in which to operate a business – the need to attract investors (who are often only interested in C corporations), the types and jurisdictions of the current or anticipated owners, the costs of initial organization and ongoing maintenance and filings, the desire to issue equity incentives to employees, plan for exit, risks of a change in the law and others. Conversion between entity types is generally possible down the line, but will involve organizational, legal, and potential tax costs. Careful consideration should be given to the needs of a business and its owners before committing to a particular choice of entity.
The contents of this Alert are for informational purposes only and do not constitute legal advice. If you have any questions about this Alert, please contact the Shulman Rogers attorney with whom you regularly work or contact us here.