Choice of Business Entity

Previously, standard choice of entity decisions often entailed forming new entities as LLCs (or other entities treated as partnerships) and converting an existing C corporation to an S corporation.

Tax reform significantly reduced the C corporation tax rate to 21% and continues to allow C corporations to deduct state income taxes in full.

While tax reform also reduced individual income tax rates, the top individual tax rate remains 37%. It severely limits an individual’s ability to deduct state income taxes, resulting in a potential significant discrepancy in the income taxes owed by a business operating in a pass-through structure compared to a similar business operated through a C corporation.

The new 20% qualified business income deduction—which is available to individuals, estates, and trusts, but not C corporations—reduces this discrepancy to some degree but doesn’t eliminate it. Accordingly, many businesses operating in pass-through entities may be interested in analyzing whether they should convert to a C corporation.

Planning Opportunities

Tax reform has greatly increased the complexity of choice-of-entity decisions. The reduction of C corporation rates to 21% has and will continue to, prompt businesses to examine whether they should convert to a C corporation.

Many business owners view the lower tax rate as an opportunity to retain more earnings to reinvest and grow their businesses, and are concerned about paying a higher tax rate than their competitors who are operating as C corporations.

While these are valid concerns—and potentially good reasons to convert to a C corporation—it’s important to assess whether these benefits outweigh the shareholder-level tax imposed on C corporations (but not on pass-through entities). Understanding how the shareholder-level tax will impact your total after-tax return requires understanding your future objectives—both for your business and personally.

When making this decision, there are three factors of consider:

  • When and how much cash do you need to take out of the business?
  • What’s your ultimate exit strategy?
  • How does the choice-of-entity intersect with your estate-planning opportunities?

More Resources

The IRS issued proposed regulations clarifying a potentially significant tax break—aggregating your trades or businesses for a pass-through, or Section 199A, deduction.

On August 8, 2018, the Treasury and the IRS issued new proposed regulations for the Qualified Business Income deduction under Section 199A.

A new qualified business income deduction provides tax relief to owners of certain domestic trades or businesses operating as pass-through entities.

Taxpayers who own and operate businesses through pass-through entities could benefit from a new qualified business income deduction.

Tax reform’s limitations on excess business losses and net operating losses from pass-through entities could prompt a tax-strategy change.

While taxes aren't the only factor to consider when choosing a business structure, it's important that your entity type still aligns with your strategic goals in light of the new tax regulations. In this webcast, we review entity choice under the new tax law, including the advantages and disadvantages of different structures.

The Tax Cuts and Jobs Act expands benefits but also limits certain tax breaks for businesses. We cover the wins and losses in our Alert.