Under the Tax Cuts and Jobs Act effective January 1, 2018 (the “Tax Act”), Congress drastically reduced the effective tax rates on business income for both C corporations and pass-through entities, such as S corporations and partnerships. The C corporation tax rate is reduced to a flat rate of 21%, and applies to both operating income and gain on the sale of assets.
The effective tax rate on S corporations and partnerships is somewhat more complicated, because the business taxable income is passed through to the owners who are then taxed at their marginal tax rate. Income tax rates for individuals have been somewhat reduced under the Tax Act, but the real tax rate break for business income for pass-through entities comes in the form of a 20% business income deduction. This deduction effectively reduces the owner’s marginal rate on the business income by 20%. To illustrate, if the owner is in a 35% rate bracket, the 20% deduction reduces the effective tax rate to 28%. One noteworthy point is that on sale by a pass-through entity, it is not clear whether the gain on sale qualifies for the 20% business income deduction. Further guidance on this latter point from the Treasury Department may be necessary.
While the effective tax rate for pass-through entities is still higher than the C corporation tax rate of 21%, many owners of businesses will find S corporations and partnerships create more overall tax savings for a few reasons. First, dividends from a C corporation are taxable to the owner at a top rate of 20%, plus the net investment income tax of an additional 3.8% if the owner’s adjusted gross income exceeds $250,000 (for joint filers). So, for the owner to receive cash from the business (other than as deductible compensation) the income is subject to a corporate rate of 21%, and then a dividend tax of 23.8%. Combining these two taxes results in an effective tax rate of 40%. Second, when the business is sold, the same double taxation applies to the sale proceeds. This compares less favorably to the S corporation and partnership structures, which, as mentioned above, have only one tax on the owner at the individual rates.
For many C corporations , owners receive cash from the business in the form of deductible compensation to “zero out” the corporation’s income, which avoids the double tax effect of the C corporation and the compensation is taxed only once to the owner-employee. Historically, this strategy put owners of C corporations largely on an equal footing with the pass-through entities since the C corporation would reduce or eliminate its taxable income by means of the deduction for compensation paid to the owner. However, under the Tax Act, this approach in many cases will not be as tax favorable compared to a pass-through entity because compensation paid to an employee, including an owner that is an employee, is not eligible for the 20% business income deduction. For example, if there is $500,000 of profit, the owners of the C corporation could be paid that ‘profit’ as deductible compensation. Assuming the owners’ marginal rate is 35%, the owners would be subject collectively to federal income tax of $175,000, plus FICA, and state and municipal income tax. On the other hand, if a partnership (or LLC) were used, the same $500,000 should be eligible for the 20% business deduction, resulting in an effective tax rate of 28% and tax of $140,000. Prior to the Tax Act, in either case, the owners would have had income tax of $175,000.
Please keep in mind that there are some limitations on the 20% business income deduction, including restrictions on the use by specified service businesses and a phase-out if certain W-2 compensation thresholds are not met. The limitations and restrictions on the deduction are complicated and you should discuss with your tax advisor if you are considering a change in your tax structure to reduce taxes.
For a more in-depth discussion of this topic and other business structure issues as impacted by the Tax Law, please join us on February 9th, 2018, for our upcoming Breakfast Briefing…https://meyersroman.com/planning-2018-beyond/