Late in 2017, the Tax Cuts and Jobs Act was passed. It will take effect in 2018.
The Tax Cuts and Jobs Act eliminated or limited a number of different tax preference items. Critically, the Tax Cuts and Jobs Act fundamentally shifted business taxation by making three significant changes:
Taken together, these changes mean that some businesses and their owners may save income taxes over time by converting from pass-through status (LLCs taxed as tax partnerships and S-corporations) to C-corporation status. Which businesses would benefit from a conversion is not clear or intuitive and requires significant analysis, based on a number of financial and tax factors. A business should also consider the risk that the new individual or corporate rates may be further adjusted by Congress in the future as well as the ramifications of a conversion for any future business exit, business succession planning, new capital investments, or equity compensation plans.
The potential for savings comes from a dramatically lower corporate income tax rate – beginning in 2018, C-corporations will pay a flat rate of 21% (down from 35%). In addition, the corporate alternative minimum tax has been repealed. This new rate will also apply to personal service corporations.
Individuals who receive dividends paid from a C-corporation are still subject to the 20% preferred dividend rate (the second level of the corporate “double taxation” regime). But, the dividend tax is only incurred when the corporation chooses to pay dividends to shareholders. Businesses that opt to retain earnings for growth are subject only to the 21% income tax rate while they may defer the tax on dividends into the future. C-corporations also gain better treatment of income earned overseas.
Tax relief was extended to owners of “pass-through” entities (S-corporations and partnerships) as well.
First, income allocated from a pass-through entity will be subject to lower individual income tax rates. The top individual rate decreased from 39.6% to 37%.
Second, the Act provides a new deduction for “qualified business income” (QBI) most often received from a pass-through entity. QBI generally includes the net amount of domestic ordinary income generated from a taxpayer’s business during the year. Investment income (e.g., interest, dividends, and capital gains) do not qualify. A partner or shareholder is eligible for a deduction of up to 20% of QBI reported on his or her individual return.
However, the QBI deduction is limited in a number of ways:
The extent to which the income from a pass-through business (and its owners) qualifies for the QBI deduction is very important in determining whether it is advantageous to explore a conversion to C-corporation status. The QBI deduction is also set to expire after December 31, 2025.
In some circumstances, converting to a C-corporation may also add an additional benefit of excluding gain on the sale of stock if the stock qualifies as Section 1202 Small Business Stock (the reach of this provision is fairly limited).
Importantly, converting to C-corporation status has some significant disadvantages, which may not be apparent from simply re-calculating the income tax due using the new income tax rules.
In the past, it has been the case that businesses are generally better off as pass-throughs (either S-corporations or partnerships). With the new rules, some pass-throughs may be better off converting to a C-corporation status if:
Because of the long-term implications of the decision (not all of which are obvious or even addressed in this overview), clients are generally taking a full look at the benefits and risks before making a decision to convert to C-corporation status.
In many cases, the decision to be a C-corporation can be made retro-active to January 1, 2018 as late as March 15, 2018.