The choice as to the appropriate type of entity to use for a business venture has historically been fairly straight forward. With regards to a closely held business, a “pass through” entity avoiding taxes at the entity level was generally the most attractive alternative if the choice was available. While there were exceptions to this general rule, they were fairly limited and specific. As a result, the overwhelming majority of existing business entities are pass through entities.
The 2017 Tax Cuts and Jobs Act makes the decision of choice of entity much less apparent. For example, assume that a taxpayer desires to sell widgets. The taxpayer wants to facilitate and memorialize a clear procedure for his business operations. He also wishes to minimize exposure to FICA taxes, and ensure that his personal assets are not at risk from any future creditors of his business. This is a very common scenario. Historically, the attorney or accountant for our taxpayer almost certainly would have recommended a limited liability company or an S corporation. If the taxpayer mentioned a C corporation, the tax advisor would shake his head and warn of the adverse tax consequences of “double taxation”.
The Tax Cuts and Jobs Act reduces the rate of corporate income tax to a flat rate of 21%. This, together with several other recent developments discussed below, fundamentally changes the analysis as to the most advantageous type of entity for a closely held business. Let’s say that a C corporation generates $100,000 of taxable income during calendar year 2018. Further assume that the shareholders of the C corporation are in the top individual marginal income tax bracket. In this scenario, what would be the “hit” of the double taxation resulting from use of a C corporation? The C corporation would net $79,000 after payment of the 21% corporate income tax. Let’s say that the C corporation distributed the full amount of its remaining taxable income in 2018. Further assume that the applicable income tax rate for our shareholders on the corporate dividends is 20%. If you take 20% of the $79,000, that would leave the shareholders $63,200. In other words, the effective, cumulative income tax rate to our shareholders would be 36.8%. If our C corporation had instead been an S corporation, the shareholders would have incurred income taxes of 37% (the top individual income tax rate) on the company’s income. In this scenario, the impact of “double taxation” has been eliminated. The result would be somewhat mitigated with the 3.8% surcharge under IRC § 1411, but the difference would be relatively minor. This example illustrates that a tax advisor can no longer use “double taxation” as de facto justification in recommending a pass through entity for a closely held business. In the modern world, the analysis of the tax advisor must go deeper.
What if the income of our taxpayer was substantially less than the above example? The income tax rate at the corporate level is a flat rate, so the 21% would not change. The rate of income tax on dividends, however, could decrease. Let’s assume that the income tax to our shareholders on dividends was 15%, and that their marginal individual income tax rate was 22%. In this scenario, a pass through entity would provide some significant income tax advantages. If the C corporation’s taxable income was $30,000, there would be $23,700 remaining to be distributed to the shareholders after payment of the corporate income tax. Given the 15% individual income tax rates on dividends, our shareholders would have $20,145 remaining after payment of corporate and individual taxes. The effective, cumulative income tax rate would therefore be 32.85%. A pass through entity, on the other hand, would result in a tax rate of only 22%. This is a material reduction. A lower income scenario, therefore, would likely suggest a pass through. Profitability could obviously change over time, so the initial selection of a pass through entity might prove inefficient if taxable income increased in future years. Periodic review by the taxpayer’s tax advisor would be important.
What factors other than the level of income are relevant? There are several. The Tax Cuts and Jobs Act created IRC § 199A, which establishes the Qualified Business Income Deduction. This deduction can allow the owners of a business to deduct up to 20% of the taxable income of the business. The deduction is only available for owners of domestic, pass through entities. C corporations do not qualify. The availability of the deduction may be contingent upon the services provided by the business. Businesses are subject to differing rules based upon whether: i.) the business provides professional services (health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services); ii.) the business’ principal asset is the reputation or skill of its owner or employees; or iii.) the business provides services consisting of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. The taxable income of the business owner must also be considered. There are a separate set of rules for taxpayers who have an annual income of: i.) $0 – $157,500 (for a single person) or $0 – $315,000 (for a married couple); ii.) $157,500 – $315,000 (for a single person) or $315,000 – $415,000 (for a married couple); or iii.) > $315,000 (for a single person) or > $415,000 (for a married couple). The salary paid to owners or employees and the basis of depreciable assets owned by the business can also have an impact on the availability of the deduction. To further muddy the waters, IRC § 199A is set to sunset as of December 31, 2025. If you may only receive eight years of benefit, you obviously have to discount the value of the deduction.
Whether the owners of a business will qualify for the 199A deduction obviously has a significant impact on the propriety of utilizing a pass through entity. While a detailed analysis of all of the specific provisions of 199A is beyond the scope of this article, suffice it to say that a tax advisor providing advice regarding the type of entity that a client should select must be intimately familiar with the rules. An analysis of whether the 199A deduction would be available if a pass through was established is a necessity.
Just as the Qualified Business Income Deduction is a potential benefit of establishing a pass through entity, classification of C corporation stock as Qualified Small Business Stock can strongly support use of a C corporation. The gain on the sale of Qualified Small Business Stock can be completely exempt from taxes under IRC § 1202. Pursuant to the Creating Small Jobs Act of 2010, the gain from sale of qualifying stock that has been held in excess of 5 years can be enjoy a 100% exclusion from capital gains. This exclusion is only available for the sale of stock in a C corporation. IRC § 1202(c)(1). The company must have owned assets having a gross value of less than $50 million at all times (IRC § 1202(d)(1)), and 80% in value of such assets must be used in a trade or business other than: i.) professional services (as listed in the statute); ii.) banking or insurance; iii.) farming; 4.) mining; or 5.) hotels or restaurant operations. IRC § 1202(e). It is important to keep in mind that the amount of the exemption is dependent upon when the stock being sold was acquired rather than the date of its sale or the purchase of the replacement stock.
An additional benefit of Qualified Small Business Stock is that it is eligible for a potentially tax free, like kind exchange pursuant to IRC §1045(a). There is a 60 day period following sale of qualifying stock during which the proceeds can be invested in replacement stock. Nonrecognition will only be available if the basis is at least equal to the gain realized on the sale. The amount of gain avoided will be used to reduce the basis of the replacement stock being purchased.
Historically, a disadvantage of C corporations was the potential for imposition of a corporate Alternative Minimum Tax. Imposition of a corporate AMT was repealed by the Tax Cuts and Jobs Act, thereby eliminating another potential disadvantage of using a C corporation.
Apart from the above technical provisions, there are also some practical considerations in evaluating the propriety of using a C corporation. The examples set forth above assume that a business will distribute all its taxable income in the year in which such income was earned. This is, of course, not necessarily the case. A C corporation is allowed to accumulate retained earnings, thereby deferring recognition of income tax on dividends paid to shareholders. Care must be taken, however, in accumulating retained earnings. Pursuant to IRC §§ 531-537, there is the possibility of an “Accumulated Earnings Tax” of 15% on retained earnings in excess of amounts retained for the reasonable needs of the business. IRC § 535(a). Fortunately, there is a safe harbor allowing up to $250,000 of retained earnings prior to potential imposition of the accumulated earnings tax ($150,000 for professional service companies). IRC § 535(c)(2).
The ability to defer payment of income taxes on dividends is a very significant benefit. Think about the seller of widgets referenced in the initial example of this article. Rather than paying income taxes at a 37% rate on the taxable income of the company, the taxpayer could reduce taxes payable on taxable income to 21% in the year such taxable income was received. The deferred tax of 16% on the taxable income of the company could then be used to purchase additional equipment or supplies, or to provide cash reserves reasonably necessary for the company’s present or future business operations. This is simply not possible with a pass through entity. The ability to defer payment of income tax provides what is effectively an interest free loan from the government. Further, a shareholder might be able to time dividends to take advantage of available losses to offset the income. While $250,000 is a safe harbor, the amount of retained earnings could significantly exceed this amount provided that the taxpayer was able to establish that the retained earnings were necessary for the reasonable needs of the business.
The purpose of this article is not to advocate use of C corporations. S corporations and limited liability companies will often provide the more appropriate option. The purpose of this article is to highlight the sophistication of the issues involved. The advice of a tax professional thoroughly familiar with the relevant law is absolutely essential to making an intelligent and tax efficient decision.