If you own a closely-held business, it likely utilizes a “pass-through” S corporation or partnership tax classification. The owners pay income tax individually on pass-through entity income, whether or not the business distributes the income.
C corporations are different. C corporations pay tax on their own income. The shareholders pay an additional dividend tax only when the C corporation distributes dividends.
Under the Tax Cuts and Jobs Act that Congress likely will pass Tuesday, the federal tax rate on retained C corporation income will drop from 35% to 21%. The top individual tax rate, which also applies to pass-through entities, will equal 37%. The Act makes C corporation tax status more attractive than in the past.
Should you convert your pass-through business to a C corporation?
Should you change the tax classification of your business?
The short-answer: Probably not, unless you plan to own the business a long time and indefinitely reinvest profits.
A longer answer:
Under the Act, converting your business into a C corporation creates a trade-off between:
- a lower tax rate on operating income, leaving more cash to reinvest in the business; and
- paying more tax (or getting a lower purchase price) when you sell the company, and having less flexibility taking profits out of the business in the meantime.
If you convert your Florida-based pass-through business to a C corporation, the business will pay state income taxes that pass-through entities avoid. The C corporation’s combined federal and state tax rate will reach just over 25% on reinvested income.
The problems? You will pay a higher or equivalent tax rate, as compared to the pass-through tax rate, if you take the profits out of the corporation. If you sell the business as a C corporation you will (1) pay about a 43% combined corporate-level and shareholder-level tax rate on the sale gain (versus a likely 20% or 23.8% rate as a pass-through), or (2) receive a lower purchase price to compensate a buyer willing to purchase the corporation stock for forgoing a tax basis step up in the corporate assets. And if laws or circumstances change, you cannot always readily convert back to pass-through status without negative tax consequences.
What’s in the Act for Pass-Through S Corporations and Partnerships?
The Act includes a new deduction of up-to-20% of income for pass-through businesses. If your business earns $10 million of income, you might qualify to deduct $2 million. The deduction would save $740,000 in federal income tax and reduce the business’ effective income tax rate from about 36% to approximately 29%.
The catch? For taxpayers with income over about $400,000 (or a lower threshold for persons other than married, joint filers), the Act limits the deduction to (1) 50% of the wages paid to employees, or (2) the sum of 25% of wages, plus 2.5% of the value of owned depreciable property. If the business earns a $10 million profit, but its payroll is $3 million, you may only qualify to deduct $1.5 million, not $2 million. Unless the business has a lot of payroll or owns substantial depreciable property, its tax rate may remain in the mid-to-high 30% range.
Despite the new deduction, the Act leaves most pass-through entity owners paying a higher tax rate than C corporations pay on reinvested business profits. But most pass-through entities retain the advantages of a lower tax rate on profits distributed to owners and on the sale of the business.
What to Do?
If you can predict future payroll and equipment purchases, the price and timing of a business sale, and Congress’ whims, you can perform a present value calculation to decide whether pass-through or C corporation tax status is best for your business. The calculation would compare the pre-business-sale tax savings from the reduced C corporation tax rate on reinvested profits, against the increased tax on distributed profits and from a future business sale.
The math is more complicated for businesses qualifying for other tax breaks, such as the Section 1202 small business stock gain exclusion. It grows even more complicated if the model considers the tax effects of an owner’s death.
If your crystal ball isn’t clear, you are stuck making best guesses about the future of politics and your business. But if you frequently take profits out of your business or imagine selling it in the foreseeable future, you probably will stick with the pass-through tax status your business already uses.
For more comprehensive information regarding the Tax Cuts and Jobs Act, follow this link to our previous post.
E. John Wagner, II