The Tax Cuts and Jobs Act of 2017 (“TCJA”) made one of the most important decisions when starting a new business--choosing an entity type, even more important. The tax considerations associated with the type of entity chosen now has greater consequences under the TCJA and should be explored in greater detail. Here, we will look at the differences in the two main categories of entity structures.
Though businesses can choose from many specific entity types, at a high level two categories exist: a corporation or a pass-through entity.
Corporations – Reduction in Tax Rate
One of the largest and most talked about provisions in the TCJA is the change in the corporate tax rate. For tax years beginning after 2017, the corporate tax rate has been reduced to a flat rate of 21% for C corporations. This is a reduction from a graduated 15%-35% tax rate under previous law. This is great news for companies that already operate as a C corporation. The main advantage of being a corporation is liability protection, but now tax rates are a close second!
Corporations may be a good idea when companies wish to reinvest earnings in the business, are looking to expand, want to easily sell the business, or wish to have greater flexibility to increase salaries and wages for employees and owners. The downside is that C corporations are subject to double taxation (the company is taxed at 21% and dividends paid to its owners are taxed upon distribution). Corporations looking to regularly distribute earnings to owners tax-efficiently may want to consider a pass-through entity.
Pass-through entities (S-corporations, partnership and sole proprietorships) do not pay taxes; instead all of the profits, losses and other tax items are “passed through” to the shareholder/partner and, in turn, reported on their individual income tax returns. Unlike C corporations, pass-through entities generally avoid double taxation. Pass-through entities can be a beneficial entity structure when owners are looking to regularly distribute earnings.
In an attempt to even the playing field with the new lower corporate tax rates, the TCJA introduced a new deduction for pass-through entities. This deduction is known as the Qualified Business Income Deduction (“QBI”) or IRC Section 199A. The deduction is up to 20% of qualified business income earned in connection with a U.S. trade or business. Sounds too good to be true, right? The deduction comes with its complexities. For a more in-depth look at QBI and its possible impact on your business entity decisions, read our blog, New 20% Qualified Business Income Deduction: An Intro to §199A.
Before you make the decision to change your entity structure(s), you should consider the following. C corporations now have a 21% flat corporate rate. This reduced corporate rate is permanent (or as permanent as any tax legislation can be until our legislature decides to change it), while the 20% QBI deduction is scheduled to sunset at the end of 2025. Even though it may make more sense to operate as a pass-through entity to receive the 20% Qualified business income deduction, there are other factors that must be taken into consideration.
If you’re a business owner and would like to discuss the entity structure that is best for you, call on The Tax Warriors® at Drucker and Scaccetti. Call on us for experienced and highly skilled advisors who will take a 360-degree look at your entire financial and tax situation, its details and advise you on the best entity structure for your facts and circumstances.