Closely Held Business Advisor: Tax Reform Creates Opportunities to Re-evaluate Corporate Structure

The times they are a-changin’. By now, it is widely known that the Tax Cuts and Jobs Act included sweeping changes affecting nearly every single taxpayer. The pervasive nature of the changes has left many taxpayers asking two big questions. How does it affect me? What should I do about it?

For decades, most businesses have chosen to operate as sole proprietorships, LLCs or S corporations. Collectively, these entities are known as “pass-throughs” since they do not pay tax, but instead pass through income or loss to the owners to report on their individual income tax return. Approximately 95% of businesses in the US are pass-through entities. The remaining 5% are C corporations. The key reason pass-through entities dominate is the double taxation that occurs when profitable C corporations distribute their profits via dividends. Under pre-tax reform tax rates, the double taxation could result in tax rates of 50% or more on C corporation income.

Tax reform lowered the corporate tax rate from 35% to 21% which has many pass-through entities wondering if it’s time to convert to C corporation status. Consider the case of a profitable S corporation that plans to reinvest earnings in the company in order to grow.  It seems intuitive that the company can more quickly accumulate earnings by converting to a C corporation and paying a 21% tax rate as compared to a higher individual rate assessed on pass-through income. Even after the application of the new qualified business income deduction the tax rate on the S corporation income will generally be 29.6%. Additionally, the C corporation can deduct states taxes, which most likely will be non-deductible if paid by the individual on pass-through income. However, assume after year two, the company owners decide they want to take a little cash out of the company as a bonus for their hard work.  The benefits of a C corporation quickly reverse into a significant additional tax burden. Let’s see how this works out:

C Corporation

S Corporation

Year 1    
Net Income

400,000

400,000

Tax Rate

21.00%

29.60%

Tax

84,000

118,400

After- Tax Cash

316,000

281,600

Year 2
Dividends to Owner (Paid from 1st year Profits)

200,000

200,000

Tax Rate

23.80%

0%

Tax

47,600

0

After-Tax Cash

152,400

200,000

Cumulative After-Tax Cash

468,400

481,600

This example is much less complex than real life. It ignores the additional state tax deductions available to C corporations, the potential to pay bonuses out of the C corporation instead of dividends, and it does not explore the tax implications on the sale of the business.

However, this analysis highlights a few key considerations for pass-through entity owners:

1. The new tax landscape has changed the old “rule of thumb” that pass-through entities are almost always better.

2. The best entity structure for your business depends on a number of key assumptions including:

  • How do you plan to utilize cash- reinvest in the business vs. distribute?
  • What is your exit strategy?
  • If you plan to sell, what is your business worth?
  • Does your business have the financial metrics, the people, processes and technology in place to maximize value upon exit?
  • Does your business qualify for the new pass-through deduction?

3. The decision making process is dynamic and complicated.

How We Can Help

Entity structure can have a major impact on short-term and long-term results. Modeling your business assumptions and outcomes is a constructive project to insure you are protecting your assets and maximizing your long-term benefits. Our team can walk you through every step of the process and help you feel confident that your approach is the perfect fit for your business.