We’ve now had a year to learn the provisions of the Tax Cuts and Jobs Act (TCJA) passed in December 2017 and how they affect taxpayers. One of the changes with the biggest impacts is the reduction of the corporate income tax rate from a maximum 35% to a flat 21%. Another is the 20% deduction for individuals for Qualified Business Income or “QBI”. With the drastic reduction in corporate rates, and a less dramatic change in the top individual rate from 39.6% to 37%, many business owners are reconsidering their choice of entity for tax reporting purposes, specifically, whether it is better to be taxed as a passthrough entity or a C corporation. Because of the relatively short window for doing the analysis and the lack of guidance available last year for making the change for 2018, a lot of taxpayers decided to postpone the decision until more guidance was available. Calendar year S corporations and LLCs taxed as partnerships or as disregarded entities now have until March 15, 2019 to change to a C corporation effective January 1, 2019. Following are considerations for business entities owned primarily by individuals.
A C corporation is the default characterization for an entity formed as a corporation under state law. A limited liability company can also make an election to be taxed as a C corporation for federal income tax purposes. Before the TCJA, a C corporation would pay a maximum 35% tax at the corporate level and another 23.8% tax at the individual level when the income was distributed resulting in an overall tax rate of approximately 50%. This, compared to a maximum 39.6% rate for income taxed directly to the individual by using a pass-through entity such as an S corporation, partnership or disregarded entity, made C corporations less attractive from a tax perspective. Now that income of a C corporation is taxed at a flat 21% rate for federal purposes, the tax differential has narrowed considerably. Under the new law, if the individual owners take a distribution of the income from a C corporation after it pays the 21% tax, the combined tax rate is 39.8%. Since the maximum tax rate on this income to an individual is now 37% it still appears to be more efficient to be taxed as a passthrough entity due to the single level of tax however, the difference is not as great. So, why are businesses taxed at the individual level considering a change to a C corporation? One answer is that not all corporations distribute their earnings to shareholders every year. Most businesses have the need for a certain level of working capital for operations, and many need cash to expand their business, acquire additional assets or service debt. To the extent corporate income is not distributed, there is a potential federal tax rate differential of 16% on income retained by the corporation. This can be a significant advantage for early stage companies, capital intensive businesses, and start-ups that need to reinvest more of their earnings to grow. Of course, eventually all earnings will end up being distributed either as dividends or liquidation proceeds (or in the form of sale proceeds if the stock is sold), meaning the overall tax will still be higher over the life of the C corporation. Another advantage for a C corporation is the ability to deduct state income taxes without limitations. The TCJA limits the amount of taxes deductible by individuals to $10,000 per year. Therefore, electing to be a C corporation, may have temporary benefits for certain taxpayers that don’t distribute earnings, and permanent benefits if the deduction for state taxes is limited at the individual level.
Partnership/Multiple Member LLC
Schedule C/Single Member LLC
Qualified Business Income Deduction
Qualified Business Income
The definition of QBI and limitations on the amount of the deduction become more complicated for taxpayers with taxable income in excess of the threshold amounts mentioned above. For these taxpayers, QBI does not include income from a specified service trade or business or “SSTB”. An SSTB is one that involves the performance of services in the fields of heath, law, accounting, actuarial science, performing arts, consulting athletics, financial services, brokerage services or any trade or business where the principal asset of trade or business is the reputation or skill of one or more of its employees or owners. The regulations help to better define what is an SSTB and what is not, however there are still many questions unanswered.
Limitations on QBI Deduction
QBI is Only Temporary
Finally, to make the decision just a little more complicated, the QBI deduction and other changes made for individuals such as the lower rates, will sunset after 2025 and return to pre-TCJA law. Many think Congress will eventually pass law to make some or all of the TCJA changes permanent for individuals, but it is uncertain.
In addition to the QBI deduction, there are other differences for C corporations and passthrough entities that were created by the TCJA. New provisions relating to international operations apply differently to C corporations and individuals. Specifically:
- C corporations and individuals are subject to the Global Intangible Taxable Income (GILTI) tax. This provision basically brings income from foreign corporations that exceeds a calculated return into US income of the owners. Under old law, income attributable to US owned foreign corporations was not taxed in the US until distributed or deemed distributed. C corporations are allowed to deduct 50% of the GILTI income inclusion and use foreign tax credits to offset US tax. Individuals are not allowed the 50% deduction with no offset for foreign taxes. Depending on the tax rate in the foreign country, a C corporation could pay as little as 0% tax on GILTI, whereas individuals could pay up to 37% on this income.
- Alternatively, the Foreign Derived Intangible Income (FDII) deduction for certain income from foreign sales to unrelated foreign parties, is available only to C corporations. This 37.5% deduction reduces a C corporation effective tax rate to 13.1% on qualifying income, which is basically income from foreign sales in excess of a calculated return.
There has been progress over the past year in defining how the new tax law will affect existing and newly forming businesses, however a fair amount of uncertainty remains. The best choice of entity for tax purposes depends on many different factors including cash flow needs of the business, projected income levels, state taxes, international operations, and future changes to the tax law. The window for changes in choice of entity for 2019 closes for most calendar year taxpayers on March 15, 2019, so there’s still time to analyze the best entity for you.
For more information, please contact Tax Partner, Roger Wilkins.