3 Scenarios to Consider Before Making Any Entity Switch
Since the historically low 21% corporate tax rate went into effect, many S corporations and partnerships have been asking themselves: Should our business switch to a C corporation? After notable investment firms Ares and KKR recently took the plunge to convert their partnerships to C corporations, entity choice has become a hot topic.
Entity selection used to be a largely one-sided contest, with nearly every private business choosing pass-through status to sidestep the 35% top corporate tax rate and double-taxation event on dividends to its shareholders. Yet even as the new tax rate represents a drastic 40% reduction over the old one, becoming a C corporation may not always be the best choice. So what is?
Take a look at the three most common tax entity scenarios. They’ll help you make an informed decision that addresses your company’s particular needs.
Scenario 1: Reinvesting More Than Distributing
Like many biotech or pharmaceutical businesses, companies eyeing long-term growth will likely reinvest any earnings back into the company to fund their growth and R&D plans. In such cases, C corporation status can offer significant tax dollar savings over a pass-through—the latter taxed, by comparison, at the 37% top personal rate. In addition, the corporation will enjoy a full state income deduction on its federal return, whereas this deduction is essentially crippled for personal returns with state tax liabilities from pass-through entity income.
On the other hand, a mature, profitable company with limited growth potential—for example, a family-owned baked goods company that distributes most of its profits to shareholders each year—may hurt itself as a C corporation. That’s due to the double taxation trap of the 21% corporate tax, followed by a roughly 24% rate at the federal level on the dividend (20% dividend rate plus the 3.8% net investment income tax), triggering an effective rate of over 50% when including state impacts. That’s well over a pass-through entity’s tax impact.
Scenario 2: Anticipating Significant Net Operating Losses
If a company expects losses for the foreseeable future, C corporation status may be the best fit here, too. That’s especially true if it plans to reinvest earnings until it turns profitable, and operates in a state where the tax rate is the same or lower than the personal flow-through rate.
While the new tax law eliminated net operating loss carrybacks, NOLs generated in 2018 or later now have an indefinite life. Even though the new NOLs can only be utilized at 80% of the taxable income, NOLs still give C corporations with a long-term strategy a cushion to offset future profits.
A loss corporation that converts to a pass-through, however, loses any NOL carryovers it has up to the entity conversion date. In addition, the recent tax reform legislation instituted new loss deduction limitations to individuals that can far outweigh the 80% NOL limitation.
Scenario 3: Pass-Through Entity Not Qualifying for New 20% Business Deduction
Competition among entities is brewing, with the 21% corporate rate vs. the new 20% deduction on a pass-through entity’s qualified business income (“QBI”). The latter deduction offsets the top individual tax rate of 37%, yielding a 29.6% effective federal tax rate. That can translate into hefty tax savings for businesses that qualify.
However, most professional services that operate as pass-throughs—such as attorneys, accountants, and financial advisors—don’t qualify for the QBI deduction. Because these professions don’t benefit from the perks of maintaining a pass-through structure, they may wish to consider a switch to C corporation status. That’s also true if they’re already reinvesting their earnings as mentioned earlier.
On the heels of enactment of the historic new tax law, now’s a good time for businesses to break out of their comfort zone and rethink their entity selection. A tax entity diagnostic is a moving formula, so any premature switch can trigger a severe tax consequences. The right tax professional will help you navigate these issues, so you know you’ve made the right decision, whichever entity you ultimately choose.
Business Tax Quarterly - Summer 2018