By Rene Schaefer, CPA MST
The Tax Cuts and Jobs Act (TCJA) was intended to reform the tax code by lowering tax rates and changing income and deductions for all businesses. Two of the most significant changes are the reduction of the C corporate tax rate to 21% and the addition of the 20% qualified business income deduction for pass-through entities (S corporations, partnerships or sole proprietorships).
Many businesses are questioning – what’s the right type of entity for my business for tax purposes?
The path to choosing the right entity starts with considering the following important questions:
- What are the plans and objectives for the company and its owners?
- Does the company need to retain money for growth or capital needs?
- What is the continuity/exit strategy of the company? Sell assets, stock or gift? When?
C Corporation Aspects
While the C corporation tax rate is 21% (previously 35%), a double tax remains–at the corporate level and at the owner level on any distributions:
- If the company distributes a dividend or sells assets, the maximum combined tax rate is 39.8%.
- If the company pays out profits as compensation, the maximum tax rate is 40.8% including Medicare tax and the surtax.
C corporations tend to make sense for companies that (1) have high cash needs and significant expected growth, (2) don’t plan to sell in the next 5-10 years, or (3) want the 100% gain exclusion for qualified small business stock (need to meet special requirements under IRC Section 1202).
Losses are kept at the C corporation level and carried forward, and there is no limitation on the deductibility of state taxes. If a C corporation retains more income than it needs, it could be subject to the accumulated earnings tax. C corporations will also need to book deferred taxes for financial statement purposes.
Pass-Through Entity Aspects
Pass-through entities are taxed to the owners with the maximum individual tax rate at 37%. If the company has qualified business income (other than specified service businesses), there is a 20% deduction and the maximum tax rate becomes 29.6%.
There continues to be a buildup of basis on undistributed income and no double tax on distributions. If an S election is made, there is a built-in gains tax for any gain on sale of assets within the first five years of the S election. This makes pass-through entities a better option for owners who take money out of their business or who plan to sell their business in the next 5-10 years.
Pass-through entities continue to have preferential capital gains rates, their losses can be taken at the owner level subject to certain limitations, and state taxes are capped at $10,000 for each individual owner.
Pass-through entities with international operations may be subject to higher tax under the new tax provisions.
The tax treatment of a business entity can be one of the most important and complex decisions a company and its owners can make. The type of entity to operate a business for tax purposes requires careful consideration and analysis, factoring in where the business is now, where it is going, and what are the needs, wants, and concerns of the company and its owners.
Please contact your Clark Nuber professional or Rene Schaefer to help you decide the best choice of entity for your business for tax purposes.
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