The Tax Cuts and Jobs Act (TCJA) reduced the highest tax rate for C corporations from 35% to a flat 21%. The TCJA also granted pass-through entities (partnerships, S corporations, trusts, estates) and sole proprietorships a 20% deduction of qualified business income (QBI). Many businesses are now wondering if they should restructure as either a C corporation or a pass-through entity. The answer? It depends.
As with most tax law changes, there is no one-size-fits-all answer. The decision must be based on an analysis of the current structure of the business and the future goals of the owners. There are two important factors to consider: distribution of earnings to owners and future sale or transfer of the business.
Businesses in which owners are paid a salary and can retain earnings in the entity may better benefit as a C corporation. The C corporation would avoid taxation of distributions and only distribute earnings as required by law. And when a C corporation is sold via stock sale, Sec. 1202 allows for the exclusion of up to 100% of the tax on that sale if the stock is qualified small business stock. However, an asset sale could result in higher tax liabilities.
Businesses in which owners distribute earnings more frequently may better benefit as a pass-through entity. Pass-through entities are not taxed on distributions of earnings to owners. There is no special exclusion of tax on the sale of pass-through entity stock, so selling, whether via stock sale or asset sale, will require more planning.
Another option is to get the best of both worlds by separating business units between a C corporation and a pass-through entity. For example, an owner could create a C corporation to hold the sales and marketing expenses, allowing the nondeductible entertainment expenses to have a lower tax cost. Or an owner could move portions of a pass-through entity to a C corporation (while being careful of the excess accumulation of earnings) to reduce the pass-through income and make it eligible for the 20% QBI deduction (Kolk, 2018).
There are a few additional factors to keep in mind when making this decision:
To find out if a restructure would be beneficial to you or your business, contact the HORNE Tax team. For additional resources, click below.
Another look at C corp. vs. S corp. in light of tax reform
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