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The Tax Cuts and Jobs Act (TCJA) forces taxpayers to reconsider whether business ventures should be conducted as a traditional C corporation or as a pass-through entity (sole proprietorship, single-member LLC treated as a sole proprietorship for tax purposes, partnership, LLC treated as a partnership for tax purposes, or S corporation).
The main reason is the new flat 21% corporate federal income tax rate.
The other big new factor is the qualified business income (QBI) deduction available to individual owners of pass-through entities. That deduction can be up to 20% of your share of passed-through QBI. But it’s only available for 2018-2025, unless Congress extends it.
Before the TCJA, conventional wisdom dictated that most businesses should be conducted as pass-through entities, because that avoided the dreaded double taxation problem that afflicts C corporations (corporate profits can be taxed once at the corporate level and again when they are passed out to shareholders as dividends). The double taxation threat still exists under the new law, but it has been toned down by the new 21% corporate rate.
Here are some common scenarios and the choice-of-entity implications under the TCJA.
Scenario 1: Venture generates tax losses
If your main concern is deducting a business venture’s losses, there’s no tax advantage to operating as a C corporation — because C corporation losses cannot be passed through to owners (like you). Better to operate as a pass-through entity and deduct the losses on your personal return.
Scenario 2: Venture pays out al profits to owners
Results with C corporation
Say you own shares in a profitable business venture that is operated as a C corporation. The corporation pays out all of its after-tax profits to you (and the other shareholders if applicable) as taxable dividends eligible for the 20% maximum federal rate. The maximum combined effective federal income tax rate on the venture’s profits — including the 3.8% net investment income tax (NIIT) on dividends received by shareholder(s) — is 39.8%: 21% + [(20% + 3.8%) x .79]. While we still have double taxation here, the 39.8% rate is pretty good.
Results with pass-through entity
Say you own an interest the same profitable business venture, but this time it’s operated as a pass-through entity that pays out all of its profits to you (and the other owners if applicable). The maximum effective federal income tax rate on the venture’s profits — including 3.8% for the NIIT or 3.8% for the Medicare tax portion of the self-employment tax (whichever applies) — is 40.8% (37% +3.8%).
If you can claim the full 20% QBI deduction, the maximum rate drops to 33.4% [(.8 x 37%) + 3.8%]. However, the QBI deduction is only allowed for 2018-2025, unless Congress extends it.
Conclusion: In this scenario, operating as a pass-through entity is probably the way to go if meaningful QBI deductions are available. If not, it’s basically a toss-up. But operating as a C corporation may be a bit simpler from a tax compliance perspective (ask your tax pro about that).
Scenario 3: Venture retains all profits to finance growth
Results with C corporation
You own shares in a profitable business venture that is conducted as a C corporation that retains all its after-tax profits to finance growth. Assume those retained profits increase the value of the corporation’s stock dollar-for-dollar, and that you (and the other shareholders if applicable) eventually sell the shares and pay federal income tax at the maximum 20% rate for LTCGs. The maximum effective combined federal income tax rate on the venture’s profits, including the 3.8% NIIT on stock sale gains, is 39.8% [21% + (20% + 3.8%) x .79]. The 39.8% rate is pretty good. And remember that the shareholder-level tax on stock sale gains is deferred until stock sales actually occur.
If the corporation is a qualified small business corporation (QSBC), the 100% gain exclusion may be available for stock sale gains. If so, the maximum combined effective federal income tax rate on the venture’s profits can be as low as 21% (21% + 0%). (For details on QSBCs, see this Tax Guy column.)
Results with pass-through entity
Say you own an interest the same profitable business venture, but this time it’s operated as a pass-through entity. The maximum effective federal income tax rate on the venture’s profits — including 3.8% for the NIIT or 3.8% for the Medicare portion of the self-employment tax (whichever applies) — on income passed through to you (and the other owners if applicable) is 40.8% (37% +3.8%). That’s a bit higher than the 39.8% rate that applies with the C corporation option. And with the pass-through entity option, all taxes are due currently. With a C corporation, shareholder-level tax on stock sale gains are deferred until shares are actually sold (advantage to C corporations).
If you can claim the full 20% QBI deduction, the maximum effective rate is reduced to 33.4% [(.8 x 37%) + 3.8%], which is significantly lower than the 39.8% rate with a C corporation. Once again, the QBI deduction is only allowed for 2018-2025 unless Congress extends it.
Conclusion: In this scenario, operating as a C corporation is probably the way to go if the corporation is a QSBC. If QSBC status is unavailable, operating as a C corporation is still probably preferred — unless meaningful QBI deductions would be available at the owner level (no sure thing — consult your tax adviser). If the full 20% QBI deduction is expected to be available, pass-through entity status might be preferred with two caveats: (1) all taxes are due currently with a pass-through entity while with the C corporation option, owner-level taxes are not due until you actually sell stock sold and (2) the QBI deduction is only allowed for 2018-2025 unless Congress extends it.
Scenario 4: C corporation will all profits paid out as shareholder-employee compensation and benefits
Closely held C corporations have historically sought to avoid double taxation by paying out essentially all corporate income to shareholder-employees as deductible salaries, bonuses, and fringe benefits. For 2018-2025, this strategy is a bit more attractive because the TCJA’s rate reductions for individual taxpayers mean most shareholder-employees (like you) will pay less tax on salaries and bonuses. In addition, any taxable income left in the corporation for tax years beginning in 2018 and beyond will be taxed at only 21%. Finally, C corporations can provide shareholder-employees with some tax-free fringe benefits that are not available to pass-through entity owners.
Conclusion: In this scenario, C corporation status still works well — except for the fact that there is no possibility of claiming the QBI deduction. If operating as a pass-through entity would open the door to significant QBI deductions, pass-through entity status might be preferred.
Scenario 5: Operate as S corporation to minimize Social Security and Medicare taxes
Nothing in the TCJA discourages the time-honored strategy of operating as an S corporation and paying modest salaries to shareholder-employees in order to minimize Social Security and Medicare taxes. In fact, the TCJA makes this strategy even more attractive for many businesses — because it maximizes the amount of passed-through S corporation income that’s potentially eligible for the QBI deduction.
Conclusion: The TCJA makes this strategy even more attractive.
Scenario 6: Venture involves holding important assets that are likely to appreciate
As in the past, it’s still generally inadvisable to hold important assets that are likely to appreciate in value (such as real estate and certain intangibles) in a C corporation. If the assets are eventually sold for substantial profits, it may be impossible to get the profits out of the C corporation without double taxation. In contrast, when appreciating assets are held by a pass-through entity, gains on sale will be taxed only once at the owner level (probably at a maximum rate of 23.8% or 28.8% for real estate gains attributable to depreciation).
Conclusion: In this scenario, nothing has changed. Pass-through entity status is still the way to go.
The Bottom Line
The TCJA’s 21% corporate tax rate (permanent), reduced rates for individual business owners (temporary), the new QBI deduction (also temporary) shift the choice-of-entity playing field. Other things being equal, C corporations are now more attractive thanks to the 21% corporate tax rate, but pass-through entities are still be preferred in some circumstances. Your tax adviser can help you sort through the options in light of the new law.