Choice-of-Entity Under the New Tax Law

Tax reform continues to impact businesses and individuals. An essential component of the Tax Cuts and Jobs Act (the Act) is the flat 21 percent tax rate for ordinary corporations.

This new rate is a substantial reduction from the previous top corporate rate of 35 percent and, consequently, many businesses not currently classified as C corporations for tax purposes are considering whether to convert to a C corporation to take advantage of this new rate.

For tax purposes, the decision on whether to operate as a “flow-through entity” (generally, a sole proprietorship and a schedule C filer, partnership, or S corporation) or as a C corporation is often referred to as a “choice-of-entity” determination. While the new 21 percent corporate rate may favor the C corporation as a choice-of-entity for certain businesses, there are other factors, both tax and non-tax, to consider when making the determination. As a result, many businesses may decide to stay in flow-through form, rather than change to corporate.

The Basics
Before diving into the details, it is helpful to first understand the basic mechanics influencing choice-of-entity decisions. Since the advent of the “check-the-box” regulations in the 1990s, taxpayers have had significant discretion when choosing the tax classification of a business entity. For instance, a state law limited liability company (LLC) with multiple owners can choose to be a C corporation, S corporation (provided the owners are qualified shareholders), or partnership. And a wholly owned LLC can choose to be classified as a C or S corporation, or to be “disregarded” for tax purposes with all of its activities reported on its owner’s tax return (typically on the schedule C). This type of disregarded entity is often referred to as a “sole proprietorship.” Further, under certain circumstances, these regulations allow an existing entity to change its classification so that an LLC classified as a partnership can convert to be taxed as a C corporation with no changes to the underlying state law entity.

There are whole sections of tax code, with hundreds of pages of accompanying regulations, governing the taxation of flow-through entities and C corporations. Yet the most important distinction between the taxation of the various entities is a relatively simple concept: C corporations are subject to two levels of taxation, one at the entity level and another at the shareholder level, while flow-through entities are subject only to a single level of tax paid by the owner. For example, a C corporation pays tax on its income, and when the income is paid out to a shareholder as a dividend, that dividend is also taxed to the shareholder, resulting in the so called “double layer of tax.” However, a flow-through entity typically doesn’t pay tax, only the owner pays tax on its taxable income distributed from the flow-through entity. Under prior law, assuming the highest applicable federal rates and the distribution to shareholders of all of a corporation’s after-tax earnings by way of taxable dividends subject to the 3.8 percent net investment income tax, the double layer of tax could result in an effective combined federal 50.47 percent tax rate for a C corporation and its shareholders. Owners of a flow-through business could pay tax at a rate as high as 43.4 percent. In contrast, the Act’s new rates result in an effective tax rate of 39.8 percent for C corporations paying out all of their earnings to shareholders (assuming highest applicable federal tax rates) and a range of between 29.6 percent to 40.8 percent (depending on the availability of the new section 199A 20 percent deduction and the applicability of the net investment income tax, and again assuming highest applicable federal rates) for owners of flow-through businesses.

This narrowing of the spread between flow-through entities and C corporations may encourage some business owners to pursue the C corporation form. But, the effective federal tax rate is only one of the tax considerations for making a choice-of-entity determination, and there are several other points to also consider.

Availability of the New Section 199A 20 Percent Deduction
When they passed the Act, Congress felt that some benefit needed to be provided for flow-through entities to, in a sense, offset the benefit that was provided corporations with the reduction in the tax rate. Therefore, Congress passed a new 20 percent deduction for qualified business income (the “20 percent QBI deduction”) earned by flow-through businesses to reduce the tax liabilities of the owners. Generally though, provided that certain tests are met, the 20 percent QBI deduction can lower the effective tax rate paid by the active owners of flow-through businesses from a high of 40.8 percent to a low of 29.6 percent for certain business income (assuming the highest federal income tax rates and depending on whether the 3.8 percent tax on net investment income applies). Since these levels of taxation would often be lower than the effective rate of 39.8 percent paid on this same business income by a C corporation and its shareholders, this new 20 percent QBI deduction may encourage eligible businesses to stay in the flow-through form, although the deduction is currently slated to “sunset” after 2025.

Note: Calculations assume the highest federal tax rates apply and all of a corporation’s after-tax earnings are distributed to shareholders by way of taxable dividends subject to the 3.8 percent net investment income tax. State income taxes are ignored.

Operations
Generally, contributions of capital into flow-through entities and C corporations (provided certain “control” requirements are met) are tax-free to both the contributor and the business entity. However, distributions of cash and property are treated differently: Flow-through entity distributions can be tax-free, while C corporation distributions are usually taxable transactions. For instance, a distribution of appreciated property from a C corporation triggers two layers of taxation—one at the corporate level, and another at the recipient shareholder level. But a distribution of appreciated property from a partnership can be tax-free.

Accordingly, businesses that routinely distribute earnings may choose the flow-through form over a C corporation to avoid the double layer of tax, especially if the income from the business will be taxed at a lower rate due to the new 20 percent QBI deduction. Alternatively, certain capital intensive businesses that do not distribute their earnings, but reinvest such earnings, may find the C corporation form advantageous because those earnings are only subject to the 21 percent rate. However, C corporations retaining earnings should beware of the accumulated earnings tax (relating to earnings retained without a demonstrated business need) and the personal holding company tax (relating to certain types of investment income).

There are other tax considerations as well. C corporations can fully deduct state and local taxes, while the non-corporate owners of flow-through entities can only deduct up to $10,000 of state and local taxes (relating to that owner’s share of the business income) under the Act. Businesses with international operations may prefer the C corporation form because a new deduction relating to foreign-derived intangible income is available only to domestic C corporations. But losses incurred by a C corporation are trapped at the entity level, while flow-through entity losses can be claimed by the owners, subject to various limitations including: tax and at-risk basis, the passive activity rules, and the new overall limitation on business losses introduced as part of the Act. Preferential tax rates relating to capital gains and other items pass through to the owners of flow-through entities but are trapped at the C corporation level.

There is always the chance that future tax legislation could change things again. For instance, if the corporate tax rate rises, businesses that previously chose a C corporation form may not be able to convert to a flow-through form without triggering material tax consequences.

Another consideration not touched upon in this insight is state and local income taxation. Operating in a state with a relatively high corporate tax rate could encourage a business entity to adopt the flow-through form.

Change in Ownership
Businesses with frequent changes in ownership may favor the flow-through form. A purchaser of an interest in a LLC classified as a partnership can receive a basis step-up in the purchaser’s share of the LLC’s assets (provided a section 754 election is properly made), entitling the purchaser to potentially higher depreciation and amortization deductions. This step-up in basis can also occur upon the death of a flow through owner when the ownership interest transfers to an estate and heirs. In contrast, the purchaser of stock in a C corporation is not entitled to the same benefits. This is also true for the purchase of stock in an S corporation. However, a purchaser may still prefer the S corporation stock over C corporation stock because future gains from operations or sales of property will generate only a single layer of tax.

On the other hand, a business with a relatively static ownership structure may be indifferent to possible basis step-ups. These types of businesses may prefer the C corporation form.

Sale/Exit Scenario
In addition to taking less liability risk, a purchaser of a business may pay a premium to purchase business assets over equity because the purchase of assets generates cost recovery tax benefits like depreciation and amortization. Generally, an asset sale can be accomplished more tax efficiently when the assets are held by a flow-through entity because the gain is only subject to a single layer of tax. For a business entity classified as a partnership, the sellers can sell their partnership interest and pay tax at capital gains rates (subject to the “hot asset” ordinary income rules) while the purchaser can take a cost basis in the underlying partnership assets via a section 754 step-up election discussed above.  

Also, the sale of S corporation stock can be structured as an asset sale via an election under sections 338 or 336 of the code and the gain is only subject to a single layer of tax. In contrast, the purchase of a C corporation’s assets results in a tax liability for both the C corporation and its shareholders (assuming the sales proceeds are paid out) and the availability of a section 338 or 336 election is limited in comparison to an S corporation.

One other differentiator that may favor classification as a C corporation over a flow-through entity is the section 1202 gain exclusion for “qualified small business stock,” available only to certain C corporation shareholders. This gain exclusion has many requirements, including the acquisition of stock at original issuance, holding the stock for at least five years, and conducting a “qualified business.” If all the requirements are met, a shareholder can exclude up to 100 percent of the gain from the sale of the stock. This gain exclusion, in combination with the 21 percent corporate tax rate, may make the C corporation form attractive for certain businesses.

Next Steps
The choice-of-entity determination under the Act is not a simple decision. While the new corporate tax rate of 21 percent is attractive, many businesses may still find the flow-through form to be advantageous.

Any business looking to make an initial choice-of-entity determination or a conversion from one type of entity to another should consult with its tax advisor to model out the various scenarios and consider structuring alternatives.