By Roman A. Basi
One of the most significant elements of the Tax Cuts and Jobs Act (HR 1, “TCJA”) is the permanent reduction of the tax rate for regular “C” corporations from a top rate of 35% to a flat tax of 21% for all C corporation income. While C corporations are no longer taxed at 15% for the first $50,000 in income, the 21% flat tax rate is still substantially lower than pre-TCJA tax rates and the income tax rates paid by high-income individuals.
However, most businesses cannot take advantage of the 21% rate because most individuals who own their own businesses, especially smaller businesses, have not formed C corporations. Instead, their businesses are owned and operated as pass-through entities: sole proprietorships, limited liability companies (LLCs) taxed as partnerships, partnerships, or S corporations (corporations taxed as pass-through entities). Such pass-through owners pay tax on their business profits at their individual tax rates, not the corporate tax rate. So, if your business is a pass-through entity, should you form a C corporation to take advantage of the new 21% corporate rate? It depends… and it’s complicated.
You can compare the rates for individuals and corporations in the charts below. The top individual rate under the TCJA is 37%, 16% higher than the 21% corporation rate. However, the fact the corporate tax rate is lower than your individual income tax rate doesn’t necessarily mean you’ll save on taxes if you form a C corporation. You may not save tax-wise for two main reasons, double taxation and an inability to take advantage of the new passthrough tax deduction, thus it may be advantageous to remain or form a pass-through entity.
Under “double taxation,” if you’re the owner of a C corporation, any direct payment of your corporation’s profits to yourself will be taxed twice. More specifically, the corporation will pay corporate income tax on profit at the 21% corporate tax rate with an additional personal income tax on what you receive from the corporation, along with dividends that are usually taxed at capital gains rates. Higher income taxpayers must also pay a 3.8% Medicare tax on net dividend and investment income. Dividends from stock owned more than one year are taxed at the long-term capital gains rate shown in the chart. So, the question is, depending on your business income, the total tax you’d have to pay on distributions to yourself or other shareholders from your C corporation. As the tax on such distributions combined with the 21% flat tax rate could equate to more than what you would pay at your individual income tax rate incorporated as an S corporation.
The determination of whether to form a C corporation or S corporation will very much depend on the applicability of the TCJA’s new tax deduction for pass-through entities. The owner of a pass-through entity can now deduct an amount equal to 20% of “qualified business income” defined as “domestic income from a pass-through entity.” However, the 20% deduction caps at $315,000 (phased out at $415,000 if filing joint and $157,500 (phased out at $207,000 for single filers). Moreover, if you’re not in a specified service business, and your income exceeds the threshold, your deduction is limited to 50% of the amount you pay your employees, or 25% of employee payments plus 2.5% of the value of your depreciable business property. If you qualify for the full 20% pass-through deduction, the effective tax rate on your pass-through income will be much lower than the individual rates for non-pass-through income as shown in the chart below.
Under our extensive analysis, we have determined if you’re making more than $415,000 in profit from your business each year ($207,500 if you’re single), being taxed as a C corporation might benefit you, especially if you’re in a service business and cannot use the 20% pass-through deduction. The service businesses or trades that do not qualify for the 20% pass through deduction are those engaged in the fields of health, consulting, law, accounting, and financial services. Yet, ambiguities have arisen as to what type of trades or services qualify as a non-qualifying trade or business. Congress, as we speak is issuing guidance on various uncertainties in the TCJA’s overhaul of the tax system. In determining Congressional intent it’s vital to seek out an expert in the field.
The TCJA has forced a lot of entities to strategically determine their structure for the upcoming year. With the mid-March deadline for entity classification filings approaching for calendar year taxpayers, it’s imperative to act now. However, don’t do anything without consulting your accountant and have him or her run the numbers for you. If C corporation tax treatment looks good, you don’t necessarily have to form a corporation to benefit. If you already have an LLC, partnership, or limited liability partnership (LLP), you can elect to have it taxed as a C corporation by filing a form with the IRS. This enables you to obtain the benefits of C corporation tax treatment without going to the trouble of actually forming a corporation.
Roman A. Basi is President of The Center for Financial, Legal & Tax Planning, Inc. (DBA Basi, Basi & Associates) and is in high demand by business owners for his expertise in financial, legal and tax matters. If you have any questions or would like to know if your company could benefit from converting to a C Corporation, call the professionals at The Center at (618) 997-3436.