Entity Choice: Is It Time for a Switch?
Joel A. Herman
The Tax Cuts and Jobs Act (TCJA) lowers the federal income tax rate for C corporations to a flat 21%. This fundamental change has caused some manufacturers currently structured as sole proprietorships, partnerships, S corporations or limited liability companies (LLCs) to ask whether it still makes sense to continue to operate as a so-called “pass-through” entity.
There are several factors to consider in order to make an educated decision about your business structure under today’s tax law.
Pros of C corporations
A flat 21% tax rate works to the advantage of C corporations that expect to report substantial profits. The tax rates on income from pass-throughs depend on their owners’ rates. For individual owners, income is taxed at federal graduated rates that top out at a 37% for 2018 through 2025, subject to a new 20% pass-through deduction under the qualified business income (QBI) rules.
This tax rate for C corporations has been permanently reduced under the TCJA, subject to any future changes in the law. However, the new QBI deduction for individuals, which was designed to create some tax rate parity between C corporations and pass-throughs, will expire at the end of 2025, unless Congress extends it.
Some manufacturers may be restricted from using pass-through structures altogether. Limitations are generally related to number of shareholders and types of eligible owners. For example, most publicly-traded companies are structured as C corporations, although a few are set up as publicly-traded partnerships.
Pluses for pass-throughs
It is important to remember that pass-through entities are still only taxed once for federal purposes—at the owner level. Pass-throughs are not federally taxed at the entity level.
However, C corporations are still potentially taxed twice. First, C corporations pay an entity-level income tax on their profits. C corporations then typically distribute their profits to shareholders as dividends, and each shareholder pays tax on these dividends when received at their respective income tax rates. Dividends also may be subject to the 3.8% net investment income tax at the individual shareholder level.
Double taxation must also be considered in conjunction with the sale or liquidation of C corporation’s assets. The C corporation would be subject to ordinary income tax on the proceeds in excess of the cost basis on the sale of its net assets, and then each shareholder would be taxed individually as the proceeds are distributed.
Manufacturing businesses that are pass-through entities generally qualify for the new QBI deduction. Most manufacturers will not be subject to the limitations on the QBI deduction that affect 1) service businesses and 2) businesses with minimal W-2 wages or fixed assets. So, individual owners of pass-through manufacturing businesses will often be eligible for the maximum deduction of 20% of QBI.
If your business is expected to report only a small annual profit, and if you as an owner will be in one of the lower marginal federal tax brackets (0%, 10%, 12% etc.), then your effective tax rate might be lower if your business is set up as a pass-through entity instead of as a C corporation. Also, in some states, including Illinois, the income tax rate on C corporations is significantly higher than the income tax rate for individuals. In addition, if your business is expected to consistently generate losses, there may be little or no tax advantage to operating as a C corporation. Losses from C corporations can no longer be carried back to claim refunds of prior years’ C corporation taxes paid—the losses can only be carried forward to deduct against future C corporation income, if any. However, annual losses from pass-though entities are generally deductible by their owners on their respective income tax returns.
Corporations are also subject to complex accumulated earnings tax (AET) rules. In general, the AET rules take effect if a C corporation retains earnings beyond the reasonable needs of the business, rather than distributing the profits as taxable dividends to the owners. If your C corporation intends to accumulate cash in the company’s bank account, consider the AET rules and related risks.
Run the numbers
When it comes to selecting a legal structure for your manufacturing business, there is no universal “best” choice. The decision requires careful consideration of various income tax, legal and state issues.
For more information, contact Joel Herman at email@example.com or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group.