Issue 2018-01

Tax Planning Considerations Under the “TCJA”

Given certain changes made to the federal income tax laws by the 2017 Tax Act (the “Act”), privately held businesses should reconsider their tax structure to determine whether it is more advantageous to conduct their businesses as pass through entities or sole proprietorships or, alternatively, as C corporations.

The Act permanently reduces the maximum incremental federal corporate income tax rate from 35% to a flat 21% tax rate effective for taxable years beginning after December 31, 2017, reduces the maximum incremental income tax rate on individuals from 39.6% to 37% for taxable years 2018 through 2025 (reverting to the pre-Act rates after 2025), and leaves the income tax rate on capital gains imposed on non-corporate taxpayers unchanged at 15% or 20% (25% for unrecaptured section 1250 gain).

In addition, the Act provides for a new 20% deduction for so-called “qualifying income” of businesses conducted through pass through entities or as sole proprietorships that could, where the deduction is applicable without limitation, reduce the maximum effective federal income tax rate on such income from 37% to 29.6%.

At the same time, for individuals for taxable years 2018 through 2025, the Act limits the deduction for state and local income taxes (whether or not related to a trade or business) and real property taxes unrelated to a trade or business or investment to $10,000 (without adjustment for inflation) and eliminates the deduction for miscellaneous itemized deductions (including legal and accounting fees for the determination of any tax).

In some cases, being treated as a corporation may offer a significant advantage over operating as a pass through. There are a variety of factors favoring corporate status, including the new 21% corporate tax rate, higher ordinary income rates for individuals, the availability of an unlimited deduction for state and local corporate income and property taxes, reduction in self-employment tax for shareholders who are active in management of the business, the potential for deferral of federal income taxation at the shareholder level, possible avoidance of current state and local income taxation at the shareholder level on dividend income (versus current state and local taxation of income from pass through entities regardless of the owner’s state of residence), and the exclusion of gain from the sale of qualifying small business stock.

In addition, on an international level, C corporations (unlike individuals and pass through entities) that derive income from the sale of goods or provision of services, as well as lease of tangible property or license of intellectual property, to foreign customers (for use or consumption outside of the United States), enjoy a reduced corporate tax rate of 13.125 (rising to 16.406 percent starting from 2026) on profits attributable to those sales (reduced by an amount equal to 10 percent of adjusted basis of the corporation’s tangible depreciable property), subject to a taxable income limitation. The reduced rates apply even when the goods and services are manufactured or performed in the United States.

Also, C corporations which are US shareholders of a controlled foreign corporation, are taxed currently on part of the profits derived through that corporation at the reduced rate of 10.5 percent, as opposed to the marginal rate of 37 percent that would apply to US individual shareholders.

Taken as a whole, these factors may create a bias toward operating as a C corporation, particularly where a business is growing and its earnings are being reinvested in the business, or a significant portion of the income of the business is derived from foreign sales.

On March 15, the deadline expires to retroactively elect C corporation status for the 2018 calendar year for S corporations, pass through entities and sole proprietorships, or elect to be an S corporation.

Taxpayers should address, through an in depth analysis of various scenarios, the income tax considerations of conducting business as a C corporation as opposed to as an S corporation or other pass through or sole proprietorship. In addition to the obvious federal income tax considerations, they should consider the potential application of the personal holding company and accumulated earnings taxes as well as state and local income taxes.