|So, is a C corporation preferred after the TCJA? The best answer: “it depends.” Many tax rules and non-tax considerations are important for choice-of-entity decisions. As shown in the following examples, the QBI deduction is a significant benefit to non-corporate businesses to complement the 21% flat rate for C corporations. However, the QBI deduction is in the law for only 2018 through 2025 while the 21% corporate rate is permanent. Of course, politics and budget needs are the key determinants of what is permanent versus temporary.|
Many tax and non-tax factors play a part in deciding on the best entity form for a new or existing business. The Tax Cuts and Jobs Act (TCJA) enacted in December 2017 added several more components to consider in this important decision. This article explains new TCJA provisions relevant to the choice-of-entity decision along with continuing factors and provides a few examples and additional considerations to help in this important business decision.
The primary reason supporting tax reform that resulted in the Tax Cuts and Jobs Act (Public Law 115-97; 12/22/17) was to lower the corporate tax rate to make the U.S. tax system more competitive with other countries. This new law enacted in late 2017, reduced the corporate rate from a progressive structure ranging from 15% to 35%, to a flat 21% rate, effective for tax years beginning after December 31, 2017. Tax reform also reduced the individual income tax rate structure, but not as dramatically. In recognition that most business entities do not operate as C corporations, the TCJA added a new deduction for other business entity types. Code §199A or the Qualified Business Income (QBI) Deduction, generally allows a deduction equal to 20% of qualified business income, with various limitations.
At 2016, federal tax data shows the following breakdown of types of business entities:1
Any major tax change is an opportunity to consider whether existing businesses are using the optimal tax structure. New tax rules also change the questions to consider when a new business is deciding on its initial entity form. This article covers the considerations as they stand after the Tax Cuts and Jobs Act, with a focus on domestic tax rules. Another significant reason underlying tax reform was to move the corporate income tax system from a worldwide-based approach to more of a territorial one like other industrialized countries use. This change also brought new complexities and tax planning considerations beyond the scope of this article. For businesses with operations outside of the U.S., the revised international tax rules, mostly affecting C corporations, must also be considered in the choice-of-entity decision.
A first question addressed as relevant to this choice-of-entity topic is whether taxes even affect this decision-making process.
Do Taxes Affect Decisions on Choice of Entity?
Someone starting a business should consider the tax and non-tax pros and cons of different entity types. The differences among entities are relevant to many operational and financing considerations including costs to operate, formality of formation, ability to borrow and obtain new equity, and termination of the entity. In addition, as a business grows or modifies its purpose, it should again consider its entity choice including taxation differences to determine if any change is desirable. Most notably, income and employment taxes apply differently among sole proprietorships, partnerships, S corporations and C corporations. Other taxes, such as local business license taxes, might also apply differently.
Data reflecting past tax law changes indicates that choice of entity decisions do affect choice of entity decisions. For example, after the Tax Reform Act of 1986, the income tax rate for individuals was lower than it was for C corporations for the first time.2 So, not surprisingly, new businesses as well as existing ones found passthrough type businesses (sole proprietorships, partnerships and S corporations) more attractive.
IRS data shows that in 1990, almost 11% of entities were C corporations, but by 2000, just under 9% were C corporations. During this time period, the percentage of business entities operating as S corporations changed from 7.85% in 1990 to 11.44% in 2000.3 Another trend during this time period was the increase in limited liability companies (LLC) which likely was due not only to the limited liability feature of this entity but also that states started allowing this type of entity in the late 1980s and early 1990s.
Drafters of the TCJA appear to have believed that the lowered corporate tax rate might at least lead some S corporations to convert to C corporations because special provisions were included to help such corporations.4
Let’s dig deeper though to see whether the TCJA is an enticement to form as or convert to a C corporation.
TCJA Changes Relevant to Choice-of-Entity Decisions
The following table shows key TCJA changes and whether they favor or disfavor the C corporation form of entity.5
|TCJA Change||Favors C Corporation?
[+, -, n/a]
|Flat rate of 21%, compared to individual graduated tax rates of 10, 12, 22, 24, 32, 35 and 37%.||
|Repeal of alternative minimum tax (AMT) for C corporations.||+|
|$10,000 cap on state and local taxes of individuals that are not directly imposed on the business (Code § 164). C corporations though, may fully deduct state income taxes while passthrough entities must treat state personal income taxes attributable to business income as an itemized deduction subject to the cap.||+|
|Excess business loss limitation of Code § 461(l) does not apply to C corporations.||+|
|Favorable accounting methods for small businesses (those with average annual gross receipts in the prior 3-year period of $26 million or less6) that are not a tax shelter per Code § 448(a)(3) and (d)(3).||-*|
|Code § 118, Contributions to the capital of a corporation.||+**|
|Quasi-territorial tax system primarily only pertains to C corporations.||+|
|QBI Deduction of Code § 199A (not available to C corporations).||–|
|Favorable depreciation rules such as 100% bonus.||n/a|
|Interest expense limitation of Code § 163(j).||n/a|
|NOL limitations (no NOL carryback and when carried forward may not reduce taxable income by more than 80%).||n/a|
n/a – the rule applies similarly to all business entity types.
* C corporations and partnerships with a C corporation partner are required to use the accrual method of accounting per Code § 448 unless they meet the definition of small based on gross receipts at Code § 448(b)(3) and are not a tax shelter. In contrast, other types of entities such as sole proprietorships, partnerships without a C corporation partner and S corporations are not subject to Code § 448. A C corporation that is a qualified personal service corporation (Code § 448(b)(2) and (d)(2)) is not subject to Code § 448 regardless of the gross receipts level, and thus, may use the cash method of accounting.
** The exclusion of Code § 118 only applies to C corporations. The TCJA significantly reduced the types of excluded income under this provision but did not repeal the rule so it still applies to limited types of contributions from non-shareholders.
Simple Examples of Effective Tax Rates on Business Income under TCJA
A comparison of the effective tax rate for a C corporation and a sole proprietor with the same amount of business income indicates that the QBI deduction helps match the 21% corporate rate and along with double taxation of corporate income results in the sole proprietor paying less income tax. The example includes two sole proprietors with different marginal tax rates (24% and the top 37% rate).
|C corporation||Sole proprietor
24% marginal rate
37% marginal rate
|Net business income||$1,000||$800||$800|
|Shareholder tax on share of after-tax earnings (assume top 20% capital gains rate on this qualified dividend) + 3.8% net investment income tax (Code §1411)||$188||—||—|
|Net earnings after tax||$602||$808||$704|
|Effective tax rate on the $1,000 of income||39.8%||19.2%||29.6%|
The above is a simplified example in that payroll taxes are not considered although the shareholder of the C corporation might also be an employee of the corporation. Also, the C corporation can defer the second layer of tax by not making a dividend distribution but needs to consider the personal holding company tax of Code §541, if applicable, and the accumulated earnings tax of Code §531 when distributions are not made.
Not all non-corporate business owners will qualify for the QBI deduction. For example, if the owner’s taxable income exceeds specified thresholds,7 there is no QBI deduction for any specified service trade or business (SSTB) such as an accounting or law practice.8 Also, if the business owner does not have an SSTB but has taxable income above the specified thresholds and no wages or unadjusted basis of qualified property, a QBI deduction is denied. If in the example above, the sole proprietor in the 37% bracket were denied a QBI deduction, the income tax would be $370 and the effective tax rate 37%. While this is still more favorable than the effective tax rate for the C corporation, if the corporation were to defer dividend payments, it would look more favorable. If the sole proprietor is not an SSTB, has taxable income above the thresholds and no wages or qualified property, it should consider converting to an S corporation so wages can be paid to the owner. If the sole proprietor is an SSTB with income above the thresholds, the C corporation form would look better assuming there are no feasible ways to reduce income to below the QBI taxable income threshold, such as with retirement plan contributions or favorable depreciation deductions.
Non-TCJA Tax Rules Relevant to Choice-of-Entity Decisions
The following chart is a reminder of various tax rules that remain unchanged by the TCJA and whether they favor or disfavor C corporations.
|Tax Rule||Favors C Corporation?
[+, -, n/a]
|Code § 1202, Partial exclusion for gain from certain small business stock, may be available. This provision allows non-corporate shareholders who acquire the C corporation stock at original issue and hold it for over five years to exclude 100% of any gain, with limitations. Strict rules apply as to what is “qualified small business stock.” If the corporation meets the definition, the C corporation form should get serious consideration in deciding upon choice of entity.||
|Code § 1244, Losses on small business stock, only applies to stock of a C corporation that has capitalization of $1 million or less. When applicable, this provision allows shareholders with original issue stock to treat a limited amount of any loss from sale or exchange as ordinary rather than capital.||+|
|Provision of fringe benefits and health insurance to owner/employees.||+*|
|Double taxation of entity income.||–|
|Personal holding company tax if the C corporation meets the definition and doesn’t distribute sufficient dividends.||–|
|Accumulated earnings tax if the corporation accumulates earnings rather than distributing them and has no documented, reasonable needs for doing so.||–|
|Code § 183, Activities not engaged in for profit, also known as the hobby loss rule which limits deductions to the amount of income produced, does not apply to C corporations. However, deductions must still meet the ordinary and necessary requirements for carrying on a business under Code § 162 to be deductible.||+|
|Charitable contribution deduction annual limit of Code § 170 is smaller for C corporations.||–|
|Choice of tax year.||+**|
|Restriction on number and type of shareholders/owners (none exist for C corporations).||+|
|Deferral of income for owners if dividends are not issued.||+|
|Tax rate on dividend income (reduced for C corporations due to the dividends received deduction of Code § 243).||+|
|Tax-exempt interest income (not favorable for C corporations because while tax-exempt to the corporation, when eventually distributed to shareholders as a dividend, it is taxable to the shareholder).||–|
|Favorable capital gains tax rate.||-***|
|Capital loss limitation (C corporation may only use a capital loss against capital gain income and there is a limited carryover period).||–|
|Loss limitations such as for insufficient basis or under the Code § 469 passive activity loss rules.||+****|
|Possible loss of certain loss carryforwards, such as net operating losses, at date of death of owner.||+|
* The health insurance exclusion and certain other fringe benefits generally offer better tax benefits for a C corporation and its employees for both income and employment taxes relative to other entity types.
** Generally, C corporations may select any month end as their tax year. A personal service corporation as defined under Code §441(i) though, is generally required to use a calendar year.
*** C corporations have no preferential rate for capital gains while individuals do. The corporate rate of 21% though, is less than the rate of 28% on collectibles and 25% on unrecaptured real property depreciation (Code§1(h)).
**** Certain types of C corporations are subject to the Code §469 loss limitations. Sole proprietors, unlike owners of partnerships and S corporations do not have a basis limit on deducting losses.
Considerations in Changing Entity Type
Should a business owner decide that the advantages of another entity type look better than for the existing entity, be sure to review the tax rules on making the conversion. If the business has losses or other carryforward items be sure to determine what happens to them after conversion. Try to project what the effect of the change is not just for the first year but for the next several years to be sure it makes sense to do the conversion.
Of course, sometimes a conversion is needed because the old entity type won’t work. For example, an S corporation that plans to add shareholders beyond the 100 limit or a sole proprietor planning to add a co-owner, must change their entity form. In these situations, if possible, it is important to make the change at the optimal time in terms of sharing of income among old and new owners and use of any loss or deduction carryforwards the old entity might have.
As explained in the charts above for both TCJA changes and pre-TCJA rules, there are numerous tax factors to consider in initial choice-of-entity decisions as well as later decisions about whether to change entity form. There are also non-tax considerations including state laws, ease of raising funds, and effect of disagreements among owners.
Following is a summary of additional considerations to aid in choice-of-entity decisions.
- Articulate and compare the goals of the business today and in the future.
- Identify the exit goals and timing for the owners.
- If special allocations among owners are desired, the partnership form should be considered.
- Several owner restrictions exist for S corporations as well as allowing only one class of stock. Regular attention is needed to be sure not to void the S election.
- If borrowing is a necessity for the business, consider the tax and non-tax effects to the entity and owners of different entity choices.
- Determine the state and local tax rules for each entity type. Some states impose taxes on partnerships and S corporations.
- Every situation and group of taxpayers are different in terms of type of business, financing and equity needs, and growth strategies. Be sure to evaluate the situation today and in the future as best you and the owners can. Be sure to perform tax and cash flow calculations to best evaluate each entity options.
- Be sure the owners consult an attorney to be sure they understand the non-tax legal differences among entity types.
1 Chart created using data from Joint Committee on Taxation, Overview Of The Federal Tax System As In Effect for 2019, JCX-9-19, p. 32, March 20, 2019; https://www.jct.gov/publications.html?func=startdown&id=5172.
2 The Tax Reform Act of 1986 created a 14% and 28% rate structure for individuals and graduated rates from 15% to 34% for C corporations, with the graduated rates starting to phaseout once taxable income exceeded $100,000.
3 IRS, The Effects of Tax Reform on the Structure of U.S. Business, p. 65, undated; https://www.irs.gov/pub/irs-soi/03legal.pdf.
4 See new provisions added by the TCJA at Code §481(d) and § 1371(f), as well as IRS Tax Reform Tax Tip 2018-179 (Nov. 20, 2018) at https://www.irs.gov/newsroom/some-s-corporations-may-want-to-convert-to-c-corporations.
5 The details of each of these rules is beyond the scope of this article.
6 The TCJA created a new definition of small for accounting method purposes at Code§ 448(b)(2) and (c) of average annual gross receipts in the prior three-year period of $25 million or less. This amount is adjusted for inflation annually and for 2019 is $26 million. See Rev. Proc. 2018-57, 2018-49 IRB 827. Entities must consider the aggregation rules of Code § 448(c)(2) and the regulations in measuring gross receipts.
7 Per Code §199A(e)(2), for 2018 these thresholds were $157,500 for single taxpayers and $315,000 for married individuals filing jointly. The amounts are adjusted annually for inflation. Once the taxpayer’s income exceeds these amounts by $50,000 (single) or $100,000 (MFJ), no QBI deduction is available for the SSTB income.
8 See Code §199A(d)(2) and Treas. Reg. §1.199A-5.