Choosing the right type of entity is a multifaceted analysis. It necessarily depends on a variety of factors, including business objectives, type of business, desire for liquidity distribution, and the ease of raising new capital. The Tax Cuts and Employment Act (TCJA), adopted in late 2017, included many changes affecting this analysis. One of the main changes to the TCJA has been to reduce the corporate tax rate from 35% to 21%. While many have predicted that this change will lead to an increase in S corps converting into C corps, such surge has not happened, yet. This article describes the main factors to take into account when choosing an entity's decision after TCJA.
Tax Rates
Advantages and Disadvantages of C Corporation Structure
TCJA reduced the federal corporate tax rate from 35% to 21%. TCJA has not changed the tax rate on distributions to shareholders. Dividends received by non-corporate taxpayers are taxable at a maximum of 20% (plus 3.8% for taxpayers subject to net investment income tax). The joint effective federal tax rate for non-corporate shareholders in the distributions of C Corps is 39.8%.
Advantages and Disadvantages of Flow-Through Structure
TCJA also proposed a reduction in the commission for non-corporate taxpayers on the income of flow-through entities. Income from flow-through entities is not taxed at the entity level but is included by the owners in the tax returns. TCJA reduced the maximum ordinary tax rate from 39.6% to 37%.
Also, TCJA provides a 20% deduction for certain business income for noncorporate taxpayers who have cash entities. This 20% deduction reduces the effective tax rate from 37% to 29.6%. To the extent that the owners of a flow-through entity include these amounts as taxable income, the amounts may be distributed by the flow-through entity at no additional cost.
Individual associates in a partnership may also be subject to account tax or a 3.8% net income tax, depending on their participation. Also, the shareholders of S Corps operating in the sector must pay reasonable remuneration, taxable at the level of ordinary income. This compensation is not eligible for a 20% deduction for certain commercial income. S Corp is responsible for paying half of the labor taxes, and the shareholder of S Corps pays the other half. Therefore, an entity's effective tax rate will depend on whether the result is subject to income tax, employment tax, or net income tax.
Planning Considerations
When comparing several effective tax rates, it is essential to determine whether the entity intends to make distributions. If a company wants to reinvest all after-tax income and does not make distributions, C Corps is likely to offer a greater opportunity for growth because after-tax income (which is subject to 21% tax) is generally higher than that of a flow-through entity (assuming the flow-through entity makes distributions to allow owners to pay taxes). On the other hand, if a company intends to distribute all of the revenue, a flow-through entity is likely to be more efficient.
In addition to the scope of this article, there are significant issues in various foreign and state tax regimes and in foreign countries that must be taken into account in any entity analysis option.
Income, Losses, and reporting obligations
Advantages and Disadvantages of a C Corporation Structure
The profits and losses of a C Corps are not transferred to its owners. Instead, the income and losses remain at the entity level. If the losses cannot be used in a current year to offset the company's revenues, they are generally transferred as net operating losses. They are available to offset losses in future years unless limited by one or more provisions of the Tax Code. Before the TCJA, companies could recover losses for two years and losses for 20 years. According to TCJA, companies can no longer recover their losses but can suffer them indefinitely. However, losses can compensate up to 80% of business revenues.
Corporations file United States federal and state income tax returns and pay taxes on their behalf. Business owners do not reflect business income in their statements.
Advantages and Disadvantages of a Flow-Through Entity
The income and losses of a flow-through entity are transferred to its owners. Losses may be available to offset the income of other companies, subject to existing loss limits and new limits imposed by TCJA. The new loss restrictions provide that only $ 250,000 ($ 500,000 for taxpayers who have a common return) of net losses from all taxpayer operations or activities can be used to offset non-commercial income.
Unlike the owners of C Corps, the owners of a flow-through entity are obligated to file U.S federal income tax returns, reflecting the entity's operations. These owners must also file tax returns in each state and place where the company has a tax liability. This cannot be very easy for large companies operating in the 50 states. Also, non-Americans generally do not want to file tax returns in the United States.
Planning Considerations
If a business intends to create losses and business owners can use them to offset income, subject to the limits of the TCJA, it may be more competent to operate as a flow-through entity. Nonetheless, if the owners do not expect to use the losses, it is preferable (depending on the size of the losses and the probability of possible limitations on net operating losses) to trap them in a corporation so that they remain available to offset future income.
Raising Capital and Exit Planning
For fundraising opportunities and planning sales or outings, the structure of the business entity can be achieved by potential investors as part of a fundraiser or by potential buyers during a fundraising event.
For example, many buyers prefer asset purchases over shared purchases because of the buyer's ability to increase the asset tax base when purchasing an asset. Therefore, a continuous flow structure that minimizes the seller's impact on the sale of assets may be preferred. The ability to increase the tax base on assets at the time of acquisition has increased to some extent due to changes made by TCJA, which have added generous premium amortization rules that allow the buyer to deduct 100% of the cost of certain activities immediately. Given these incentives to increase the tax base and create more immediate deductions, buyers are generally unwilling to pay the same for buying stocks.
Contrary to the buyer's motivations in the acquisition, business owners prefer to sell stocks because they result in a single level of tax on any profit from the sale of their stocks. Unless a section 338 election is made by the parties, the sale of shares does not provide a basic increase in the company's assets. From the seller's perspective, a sale of business assets results in two levels of taxation: one at the business level and the other at the shareholder level when distributing the proceeds of the property's sale. As a result, business owners generally prefer to sell stocks—which does not allow the development of their assets. However, given the perceived disadvantages for buyers, buyers pay less for the sale of stocks than they would pay for the sale of assets.
On the other hand, a transfer structure can offer greater exit flexibility, since business owners are generally indifferent between a sale of assets and a sale of interests within the business because both transactions provide a step-up in the tax basis of the assets for the buyer.
In an S corps flow-through structure, owners may prefer to sell shares, as this generates a capital gain. If the S Corp sells assets, there is only one level of taxation, but part of the income may be taxed at common rates, depending on the nature of the assets sold.
Bottom Line
Although changes in tax treatment, rates and revenues, and revenue programs for C corps and flow-through entities have been modified by TCJA, the determination of the ideal entity choice continues based on business needs of the entity, including several factors such as what the company does and the type of assets it owns, who owns it, the type of income or losses it should generate, the cash needs of business and owners, and expectations in an exit event.
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