by Kenneth S. Wear and Christine M. Green
Clark Hill PLC is an IMA member…
Prior to tax reform, tax considerations tipped the scale heavily in favor of operating a business through a partnership or other pass-through entity rather than a corporation. Now that the corporate income tax rate has been significantly reduced, choice of entity decisions are a much closer call.
Previously, the top corporate income tax rate was 35%. However, for tax years beginning after December 31, 2017, the corporate income tax rate is a flat 21% rate. Unlike other provisions in the recently passed tax reform, this rate reduction is not set to expire in the future.
Corporations traditionally are viewed as not being tax efficient because of the commonly referenced “double taxation” on corporate earnings: corporations are taxed on their taxable income, and shareholders of corporations are taxed on any dividends received. For individual shareholders, dividends from domestic corporations often satisfy the requirements to be treated as “qualified dividends” which are taxed at the same preferential rates that apply to long-term capital gains, a top rate of 20%. If such dividends fail to meet the requirements of “qualified dividends”, then the ordinary individual rates would apply. Some taxpayers may also be subject to the 3.8% net investment income tax with respect to dividend income. Under the old rules, the result was an effective combined rate on distributed earnings of about 50%; the lowered corporate rate brings that down below 40%.
Pass-through entities such as partnerships, LLCs taxed as sole proprietorships or partnerships, and S corporations are not subject to income tax at the entity level. Rather, the owners of a pass-through entity take into account their allocable share of the entity’s items of income, gain, loss, deduction, and credit. Owners who are individuals are subject to income tax at a top rate of 37% for tax years beginning after December 31, 2017, and before January 1, 2026, compared to the previous top rate of 39.6%—a much more modest reduction than the 14 point rate cut for corporations.
In addition to lowering rates, tax reform added a special deduction for non-corporate taxpayers referred to as the qualified business income deduction. In general, non-corporate taxpayers may deduct up to 20% of their qualified business income from a partnership, S corporation, or sole proprietorship. For example, if a pass-through entity owned by an individual has $100 in earnings and all of the earnings are qualified business income, then only $80 of the earnings would be subject to tax ($100 – ($100 X 20%)). The individual would owe $29.60 in tax based on the top tax rate applicable to individuals ($80 X 37%)—an effective rate of around 30%. In some cases, however, the amount of the deduction may be significantly reduced due to limitations based on W-2 wages paid by the qualified business and its adjusted basis in certain acquired depreciable property. Most income earned in service professions (including legal, accounting and health services) does not qualify for the deduction.  Investment-type income, compensatory income, and income that is not effectively connected with a US trade or business also do not qualify.
The qualified business income deduction will not apply to tax years beginning after December 31, 2025, at which point the top individual rate is also scheduled to return to 39.6%. Once the deduction expires and the lower individual rates return to pre-2018 levels, the effective top tax rates on income earned by corporations and pass-throughs will be very similar. For example, assume a business has $100 in taxable earnings which are distributed to the individual owner. If the business is a corporation, the corporation would owe $21 in tax ($100 X 21%). The corporation would then have $79 left over to distribute to its owner ($100 – $21). Assuming that the dividends are qualified dividends and the owner is subject to a rate of 20% with respect to the dividends plus the 3.8% net investment income tax, the owner would owe $18.80 ($79 X 23.8%). Out of the $100 of corporate earnings, $39.80 would be paid in tax ($21 + $18.80). If the business is a pass-through, the business entity would not owe any tax but the individual owner would be subject to a top rate of 39.6% on the $100 of earnings and would owe $39.60 in tax.
These examples obviously are very simple, apply the top tax rate for individuals, and do not take into account particular circumstances such as non-qualified dividends or income that does not qualify for the qualified business income deduction. The examples are intended to illustrate that moving forward for some taxpayers, the tax advantage pass-through entities had over corporations has been significantly narrowed.
Choice of Entity:
Because of the significant reduction in the corporate income tax rate, we may see more businesses choosing to organize as corporations rather than partnerships. While in many cases the pass-through structure currently provides an overall lower tax rate because of the qualified business income deduction, such deduction is only in place through 2025. Also, if a business intends to retain profits as opposed to distributing dividends, then the earnings would only be subject to the 21% corporate income tax rate—the individual tax on dividends would be deferred until any such dividends were paid—making the advantage of operating as a corporation even more pronounced. This could also be true for businesses that intend to use earnings to compensate shareholders who are service providers through salaries or wages as opposed to dividend distributions. In addition, for taxpayers with international business operations, holding foreign entities through US pass-through structures may result in an increased tax burden because of changes to Subpart F of the tax code that will increase income inclusions from foreign operations of many US taxpayers, including individuals. However, taxpayers with taxable income falling below the threshold amounts of $315,000 for joint filers and $157,500 in all other cases, may take advantage of the 20% deduction with respect to income from a specified service trade or business.
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