‘Plus Ça Change, Plus C’est la Même Chose?’*
(*An epigram by Jean-Baptiste Alphonse, literally, The more it changes, the more it’s the same.)
With the Tax Cuts and Jobs Act (2017 tax act) establishing a flat corporate tax rate of 21 percent (IRC Section 11(b)), reducing marginal tax rates on individuals (See IRC Section 1(j)), and creating a new 20 percent deduction for qualified business income for sole proprietorships and pass-through entities (IRC Section 199A), practitioners and their clients will need to revisit the issue of whether a small closely-held business should operate as a C corporation rather than, as most practitioners advised before the 2017 tax act, a partnership or S corporation. This analysis is particularly timely given the final regulations were recently issued for the qualified business income deduction. This article offers several examples indicating that, for most small businesses, the S corporation remains the more tax efficient choice of entity after the 2017 tax act.
The article first lists the major tax advantages and disadvantages of various business entities and then provides an overview of the new deduction for qualified business income (QBI). Several examples offer a template for measuring the after tax profit of an S corporation (with or without the IRC Section 199A deduction) and indicate that the C corporation remains less tax efficient than an S corporation for the conduct of small business. The paper concludes with a discussion of those circumstances where a C corporation may nevertheless have advantages over a pass-through entity, but those advantages are the same as under prior law without regard to the changes enacted by the 2017 tax act.
TAX RATES—IN GENERAL
Before the 2017 tax act, the highest corporate income tax rate was 35 percent (IRC Section 11(b)) and the highest rate of tax on qualified dividends received by an individual was 23.8 percent, i.e., 20 percent (IRC Section 1) plus the 3.8 percent tax on net investment income (IRC Section 1411). As a result, under prior law, the overall effective rate on corporate income distributed to individual shareholders was 50.47 percent, i.e., 35 percent taxable income plus 15.47 percent (65 percent of taxable income times 23.8 percent).
Also, prior to the 2017 tax act, sole proprietorships and owners of pass-through entities were subject to a maximum marginal rate of 43.4 percent, i.e., 39.6 percent (IRC Section 1(a) to (e)) plus 3.8 percent if the income was not subject to self-employment (SE) tax. Beginning in 2018, and ending in 2026, the highest individual rate is now 37 percent (IRC Section 1(j)(2)) resulting in an effective rate of 40.8 percent when the net investment income tax applies.
With the corporate income tax rate now a flat 21 percent and the corporate alternative minimum tax (AMT) repealed (See IRC Section 55(a)), a C corporation distributing all of its after tax profits as dividends to individual shareholders in the highest tax bracket results in a maximum effective rate of 39.8 percent, i.e., 21 percent of taxable income, plus 79 percent of taxable income times 23.8 percent. Thus, the reduction in corporate and individual tax rates after 2017, reduces the highest marginal effective rate on business income from 50.47 percent to 39.8 percent for a C corporation distributing its after-tax profit and from 43.4 percent to 40.8 percent for pass-through entities. It should be noted that for very small corporations with taxable income of less than $50,000 the 21 percent rate is actually a tax increase from the prior law rate of 15 percent. See IRC Section 11(b) prior to amendment by the 2017 tax act.
ADVANTAGES/DISADVANTAGES OF ENTITY SELECTION BEFORE AND AFTER THE 2017 TAX ACT
Aside from the change in corporate and individual effective tax rates after the 2017 tax act, there remain the same plethora of tax factors that must be taken into account to determine the optimal tax efficient choice of entity for a small business. Below is a table setting out some of the major considerations:
Because being a C corporation subjects the taxable income of a business to double taxation, most closely held small businesses have chosen to be taxed as either an S corporation or as an LLC (most often taxed as an S corporation by checking the box). An added advantage of an S corporation is that its shareholders avoid self-employment tax on their distributive share of profits. While LLC members often attempt to avoid SE tax by analogy to being limited partners (IRC Section 1402(a)), courts have universally rejected this position, especially where the owners perform services (See, e.g., Joseph Radtke, S.C. v. United States).
With the 21 percent flat corporate rate now lower than most individual marginal rates and the QBI deduction reducing the effective tax rate on pass-through entity income, the general conclusion that a pass-through entity is necessarily the most tax efficient choice of entity needs re-examination. In short, the disparity in tax rates between individuals and corporations must be compared with the impact of the QBI deduction for individuals to re-determine the best after tax return for small business persons.
QUALIFIED BUSINESS INCOME
Much of the discussion surrounding the re-examination of whether a small business should operate as an S corporation or C corporation centers on qualification for the new deduction of 20 percent of “qualified business income” (QBI). IRC Section 199A provides for a 20 percent deduction on QBI for taxable years beginning in 2018 through 2025. Thus, for an individual subject to the 37 percent marginal tax rate, QBI is taxed at an effective rate of 29.6 percent.
The QBI deduction is determined for each trade or business of the taxpayer (other than a C corporation) and is 20 percent of the net amount of income, gain, deduction, and loss with respect to each qualified trade or business of the taxpayer (IRC Section 199A(c)(1); Treasury Regulation Section 1.199A-1(c)(1)). In general, the same rules for determining taxable income are used in determining QBI for measuring the 20 percent deduction (Treas. Reg. Section 1.199A-3(b)(1), IRC Section 1.199A-3(b)(2)). Thus, for example, the same depreciation rules and IRC Section 179 elections for measuring taxable income are adopted for determining QBI. If there is an overall loss from all qualified trades or businesses the loss is carried forward as a separate loss to the next taxable year in measuring QBI for the subsequent year (IRC Section 199A(c)(2); Treas. Reg. Section 1.199A-1(c)(2)(i)).
Individuals with taxable income exceeding certain thresholds ($157,500 or $315,000 for individuals filing jointly) are subject to limitations on the deduction based on W-2 wages paid by each qualified trade or business and each business’s unadjusted basis in acquired qualified property (IRC Section 199A(b)(1), (3)). Qualified property for this purpose is tangible depreciable property whose unadjusted basis is taken into account for the longer of its recovery period or 10 years (IRC Section 199A(b)(6)). The limitation on the deduction is phased in for taxable income exceeding the threshold amount with the limit fully phased in when taxable income reaches $207,500 ($415,000 for joint filers) (IRC Section 199A(b)(3)(B)).
Computation of Deduction
If an individual’s taxable income for a year does not exceed the threshold amount the deduction is 20 percent of the net QBI for the year without regard to wages or property of the business (IRC Section 199A(b)(3)(A)). But, as noted above, where taxable income exceeds the threshold amount the deduction is the lesser of:
- 20 percent of QBI, or
- the greater of:
- 50 percent of the W-2 wages with respect to the qualified trade or business, or
- the sum of 25 percent of the qualified business’s W-2 wages, plus 2.5 percent of the unadjusted basis, immediately after acquisition of all qualified property, at the end of the taxable year (IRC Section 199A(b)(3)(B)).
W-2 wages are those wages under IRC Section 3401(a) paid to employees subject to withholding including elective deferrals and deferred compensation paid by the business during the taxable year (Treas. Reg. Section 1.199A-2(b)(2)(i)). W-2 wages for this purpose only include amounts reported to the Social Security Administration on or before the 60th day after the due date (including extensions) for an employment tax return (Treas. Reg. Section 1.199A-2(b)(2)(iii)).
Finally, in the case of a pass-through entity, the QBI, W-2 wages, and unadjusted basis of property are determined at the entity level with each partner or shareholder taking into account each owner’s allocable share to compute the deduction (IRC Section 199A(f)(1)).
If an individual’s taxable income exceeds the threshold amount by no more than $50,000 ($100,000 for joint filers) and 20 percent of QBI exceeds the greater of the 50 percent or 25 percent W-2 wage limit, the deduction is calculated by subtracting the W-2 wage limit from 20 percent of QBI and multiplying it by a phase-out percentage arrived at by dividing the amount by which taxable income exceeds the threshold by $50,000 ($100,000 for a joint filer). This amount is then subtracted from 20 percent of QBI to arrive at the deduction (IRC Section 199A(b)(3)(B)).
Example 1: X files a joint return with QBI of $150,000 and taxable income of $365,000. Wages paid by the business are $20,000. Therefore, X’s phase-out percentage is 50 percent, i.e., ($365,000 - $315,000)/$100,000, and the deduction is as follows:
Example 2: Same facts as above except X’s taxable income is $415,000 so that X’s phase-out percentage is now 100 percent ($415,000 - $315,000/$100,000) and the deduction is fully subject to the wage limitation, i.e., $10,000.
Example 3: Same as Example 1, except no wages were paid. Consequently, the full 20 percent of QBI is subject to the 50 percent phase-out percentage and the deduction is as follows:
These examples demonstrate that if an individual’s taxable income equals or exceeds the threshold amount by $50,000 ($100,000 for joint filers) and no wages were paid or assets used in the business, no QBI deduction can be claimed. Unfortunately, many taxpayers are likely to make a choice of entity decision based on the belief they are eligible for a QBI deduction only to discover that the lack of wages and assets in the business will disqualify them from the benefit.
Thus, an individual filing a joint return with QBI of $700,000 and other income exactly offset by the standard deduction or itemized deductions would have taxable income of $560,000 ($700,000 - 20% of $700,000) and a tax of $147,379, which is approximately equal to a 21 percent tax on $700,000 if the QBI were earned by a C corporation. Therefore, assuming the business is eligible for the maximum deduction, until QBI exceeds $700,000 an individual filing jointly should not consider operating her business as a C corporation.
Qualified Trade or Business
A qualified trade or business for purposes of IRC Section 199A is any trade or business other than a specified service trade or business (described below) or the business of performing services as an employee. The taxpayer need not materially participate in the business in order to qualify for the deduction (IRC Section 199A(d)(1)).
Only income effectively connected with the conduct of a U.S. trade or business qualifies for the deduction (IRC Section 199A(c)(3)(A)(i); Treas. Reg. Section 1.199A-3(b)(i)(A)) and QBI is net of reasonable compensation to the business owners as well as guaranteed payments and other payments to partners for services rendered to a partnership (Treas. Reg. Section 1.199A-3(b)(1)(ii), IRC Section 1.199A-3(b)(2)(ii)(I)). Finally, income from the following does not constitute QBI (IRC Section 199A(b)(1), IRC Section 199A(c)(3)(B); Treas. Reg. Section 1.199A-3(b)(2)(ii)):
- Qualified REIT dividends and publicly traded partnership income. These items are separately included in the final QBI deduction calculation.
- Short and long term capital gains and losses.
- Dividends, investment interest and other nonbusiness passive income.
- Commodity and foreign currency gains and losses.
Specified Service Trade or Business
The following fields are “specified service trades or businesses” (SSTBs) and do not constitute qualified trades or businesses for the deduction (IRC Section 199A(d)(2); Treas. Reg. Section 1.199A-5(b)):
- Actuarial science
- Performing arts
- Financial services
- Brokerage services
- Investment management
- Dealing in securities
- Any business where the principal asset is the reputation or skill of one or more of its employees or owners.
Despite SSTBs not being qualified trades or businesses, individuals with taxable income below the threshold amount may still treat such service income as QBI and claim the deduction, subject to a phase-out as taxable income exceeds the threshold by up to $50,000 ($100,000 for joint filers) as illustrated below (IRC Section 199A(d)(3)).
Example 4: Y, a single individual, operates an SSTB with net income of $100,000 and taxable income of $200,000. Y may claim the QBI deduction subject to a phase-out as follows:
Therefore, service businesses whose owners have taxable income below the threshold amounts ($157,500 or $315,000 for joint filers) and even those with taxable income within the phase-out ranges ($207,500 or $415,000 for joint filers) should probably not incorporate.
Finally, it should be noted that incorporated service businesses such as those listed above are now taxed at the flat 21 percent rate and are no longer subject to a flat 35 percent rate imposed on qualified service corporations under prior law (IRC Section 11(b)(3) prior to amendment by Section 13001(a) of the 2017 tax act).
SHOULD AN S CORPORATION REVOKE ITS S ELECTION?
Perhaps the best approach to determine if a small business operating as an S corporation should revoke its S election and operate as a C corporation is to set out examples from which a rudimentary decision making template may be created. Below are two examples that compare the after-tax operation as an S corporation (with and without a QBI deduction) with a C corporation.
The examples below presume that the shareholder(s) of the S corporation may deduct 20 percent of the corporation’s QBI and are not limited by the W-2 wage or the UBIA limitations nor by the 20 percent taxable income limit. Wage income may be imputed to S corporation shareholders who perform services. See e.g., Rev. Rul. 74-44, recharacterizing dividends as compensation to employee/shareholders of an S corporation.
Example 5: A qualified trade or business has $1 million pre-tax profit, subject to the highest individual income tax rate (37 percent) and a 6 percent state income tax on both corporations and individuals. State law permits a QBI deduction. Whether states will disallow the QBI deduction, as they often do with accelerated depreciation, remains to be seen.
This example demonstrates that an S corporation shareholder at the highest individual federal tax rate achieves a better after tax return compared to a C corporation owner who receives all the C corporation after tax profit as a dividend. In addition, where the shareholder of the S corporation is eligible for the full 20 percent QBI deduction, the effective after tax rate of return on the S corporation income increases by over 8 percent from 59.2 percent to 67.4 percent.
However, in evaluating the choice between a C corporation and an S corporation, it is important to note that the second layer of tax on C corporation earnings arises only when the shareholder receives a dividend from the corporation.
Thus, in the above example, the cash available to the C corporation after payment of the corporate tax ($742,600) exceeds the after tax return for the S corporation and raises the question whether the C corporation expects to pay dividends or reinvest the profits in the business. This policy decision is critical to the choice of entity decision when the corporate tax rate is substantially lower than the highest individual rate.
Where the preceding example compared the S corporation versus C corporation question using the highest individual tax rate, the example below examines the issue using lower rates of shareholder taxation.
Example 6: A qualified trade or business has $100,000 of pre-tax net income and the business’s owner is subject to a 15 percent federal marginal tax rate. The income is also subject to a state income tax of 6 percent at both the corporate and individual level.
Similar to Example 5, taking into account all corporate and shareholder income taxes, the S corporation remains after the 2017 tax act the optimal choice of entity on an after tax basis, whether or not the QBI deduction is available. In short, the QBI deduction and the 21 percent corporate tax rate will not change the traditional decision to operate a small business as an S corporation. Of course, this analysis does not mean one size fits all but it does offer the following conclusions regarding the 2017 tax act’s impact on the choice of entity decision:
- Very small entities that are not expected to grow and are eligible for the QBI deduction, should elect pass-through entity treatment. In fact, for such entities the 21 percent flat corporate rate has no appeal in that the new rate is actually a tax increase from the prior law rate of 15 percent on the first $50,000 of corporate taxable income.
- Any entity that expects to distribute current earnings to its owners are likely better off as a pass-through entity due to the immediate impact of the second layer of tax on dividend distributions to shareholders of C corporations. Generally, based on the above examples, entities expecting to distribute even a modest percentage of their earnings will likely benefit more by being an S corporation than a C corporation.
- Entities anticipating high growth in earnings which will be retained and reinvested in the business are likely candidates to operate as C corporations. Such businesses will benefit from the 21 percent corporate tax rate and minimize the tax on distributions to shareholders. In addition, shareholders may be able to sell C corporation stock utilizing the special exemption of IRC Section 1202 or the step-up of stock basis to fair market value if sold after death. In any event, the buyer may not fully discount the purchase price for the taxes on the retained earnings if and when they are distributed.
- While there is an incentive to accumulate earnings at the corporate level for as long as possible, perhaps until death, the long ignored tax on unreasonable accumulations of income could be invoked to prevent abuse (IRC Section 531). And, in addition, the personal holding company tax (IRC Section 541) might also apply to force dividend distributions of closely-held corporations whose income was predominantly from passive sources.
ADDITIONAL CONSEQUENCES OF CHANGING S OR C CLASSIFICATION
If an entity, after taking into account the lower corporate tax rate and the QBI deduction, decides to change its status from C to S corporation or vice versa, there are several additional technical consequences from the decision. First, in converting from a C corporation to an S corporation, any excess of the fair market value of the assets of the C corporation over their bases constitutes a net built-in gain which is subject to corporate level income tax if within five years after the S election the assets are sold or the S corporation is liquidated (IRC Section 1374).
Therefore, a fast growing business with a need to reinvest its earnings may choose to operate as a C corporation, converting to an S corporation to distribute current earnings when the need to retain capital declines. However, the S corporation will need to wait five years from the effective date of the S election before selling any property whose appreciation is attributable to the period it was a C corporation.
Conversely, for any corporation revoking its S election to take advantage of the 21 percent tax rate, the 2017 tax act has a special provision that allows for a six-year recognition period for any IRC Section 481 adjustment arising from the revocation (IRC Section 481(d)(1)). Specifically, the six-year period applies only to an “eligible terminated S corporation,” defined as any C corporation that was an S corporation immediately before enactment of the 2017 tax act (Dec. 22, 2017) and revokes its S election within two years after that date. In addition, the owners of the corporation at the time of revocation must be the same persons who owned the corporation in the same proportions as on the date of enactment of the 2017 tax act (IRC Section 481(d)(2)). In addition, a corporation revoking its S election may extend its post termination transition period so that distributions by the C corporation are treated as nontaxable amounts from the S corporation’s accumulated adjustment account (AAA) rather than taxable dividends from earning and profits (E&P) (IRC Section 1371(f)).
Ideally, the effective tax rates for C corporations and pass-through entities would not be relevant in determining the choice of entity for a business. However, as this article has shown, the differences in rates remains significant even with the new 21 percent corporate rate, the reduction in individual rates and the QBI deduction.
To the extent a business expects to retain its earnings, the new law encourages operation as a C corporation but the retention should be for a considerable period and the owners of the corporation should take into account that a sale of stock may be preferable to taking distributions.
Finally, if an entity expects to distribute earnings annually, operating a small business as a pass-through entity remains optimal. Nevertheless, each taxpayer will need to re-evaluate its choice of entity decision in light of the new law, cognizant that more changes in rates and deductions are likely in this volatile political environment.
Professor Donald Williamson, the Kogod Eminent Professor of Taxation and the Howard S. Dvorkin Faculty Fellow, is chair of the Department of Accounting and Taxation, director of the Masters of Science in Taxation degree program, and executive director of the Kogod Tax Center at the Kogod School of Business of American University.
Dr. David Harr is currently an Executive in Residence at American University. He received his B.B.A and Ph.D. in Accounting from the University of Wisconsin-Madison. He has published in a variety of journals and has conducted seminars on financial accounting standards, performance evaluation, and cost management for businesses, not-for-profit organizations and CPA societies throughout the U.S. Dr. Harr is a Certified Public Accountant (Virginia) and a Certified Government Financial Manager.