2017 Tax Act: Choice of Entity

by White and Williams LLP
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White and Williams LLP

We recently prepared an alert on the new 20% qualified business income deduction that was added by the 2017 Tax Act. We have received many questions from our clients and friends about whether, notwithstanding the QBI deduction, they should consider doing business as a C corporation, particularly since the 2017 Tax Act lowered the corporate income tax rate to 21% and eliminated the corporate alternative minimum tax. 

The basic question is as follows: given the new 21% corporate income tax rate, will shareholders in a C corporation realize a better net after tax result (compared to doing business as a pass-through entity) where the highest personal income tax rate on ordinary income is 37%? The long term capital gain, qualified dividend, and the net investment income tax rates all remain the same under the 2017 Tax Act (20%, 20% and 3.8%, respectively), so the focus is on the income tax rate differential. 

Doing business as a C corporation as opposed to a pass-through entity (typically a LLC or an S corporation) involves many considerations, including the impact of the entity choice on non-income tax issues. However, we wanted to focus our discussion on the federal income tax issues by using a net after tax analysis that compares the results from operating income and sale proceeds perspective.

Assumptions

We made the following assumptions for purposes of our illustration:

Federal Corporate Income Tax Rate

21.00%

Federal Individual Income Tax Rates

 

  Ordinary Income Tax

37.00%

  Capital Gain Tax

20.00%

  Qualified Dividend Tax

20.00%

  Medicare (Net Investment Income) Tax

3.80%

Qualified Business Income Deduction

20.00%

Taxable Operating Income (Ordinary Income)

$1,000,000

Operating Income Cash Flow

$1,000,000

Taxable Sale of Business Income (LTCG)

$25,000,000

Taxable Sale of Business Cash Flow

$25,000,000

Operating Income

We then wanted to compare the results from operations based on a LLC/S corporation with the benefit of the 20% QBI deduction, a LLC/S corporation without the benefit of the 20% QBI deduction, and a C corporation. For this illustration, we assumed that the cash was distributed to the owners.

Operations-Taxable Income with Distributed Cash

LLC/S Corp

With QBI Deduction

LLC/S Corp

C Corporation

       

Taxable Operating Income

$1,000,000

$1,000,000

$1,000,000

Qualified Business Income Deduction

($200,000)

   
       

Taxable Income

$800,000

$1,000,000

$1,000,000

       

Ordinary Income/Corporate Tax

$296,000

$370,000

$210,000

Dividend (net after corporate tax)

   

$790,000

Qualified Dividend Tax

   

$158,000

Medicare Tax

   

$30,020

       

Total Tax

$296,000

$370,000

$398,020

       

The net after tax cash flow under this illustration is as follows: 

Operations-Cash Flow

LLC/S Corp With QBI Deduction

LLC/S Corp

C Corporation

       

Operating Income Cash Flow

$1,000,000

$1,000,000

$1,000,000

       

Total Tax

$296,000

$370,000

$398,020

       

Net After Tax

$704,000

$630,000

$601,980

       

The net after tax for both pass-through entity illustrations is higher than the C corporation model due to the higher aggregate tax rate on the C corporation income (21%) and the dividends received by the shareholders (23.8%).

Sale Proceeds

If we then factor in the sale proceeds analysis (assuming an asset sale), the results are as follows: 

Sale of Business-Taxable Income

LLC/S Corp

With QBI Deduction

LLC/S Corp

C Corporation

       

Taxable Sale of Business Income

$25,000,000

$25,000,000

$25,000,000

Qualified Business Income Deduction

     
       

Taxable Income

$25,000,000

$25,000,000

$25,000,000

       

Capital Gain/Corporate Tax

$5,000,000

$5,000,000

$5,250,000

Dividend (net after corporate tax)

   

$19,750,000

Qualified Dividend Tax

   

$3,950,000

Medicare Tax

$950,000

$950,000

$750,500

       

Total Tax

$5,950,000

$5,950,000

$9,950,500

       

The net after tax cash flow under this illustration is as follows: 

Sale of Business-Cash Flow

LLC/S Corp

With QBI Deduction

LLC/S Corp

C Corporation

       

Taxable Sale of Business Cash Flow

$25,000,000

$25,000,000

$25,000,000

       

Total Tax

$5,950,000

$5,950,000

$9,950,500

       

Net After Tax

$19,050,000

$19,050,000

$15,049,500

       

The net after tax proceeds received by the owners for both pass-through entity illustrations is higher than the C corporation model, again, due to the higher aggregate tax rate on the C corporation income (21%) and the dividends received by the shareholders (23.8%).

It is apparent that the double tax effect for C corporations makes the results favor the pass-through entity approach of a LLC/S corporation. But what if we assume the entities retain all cash, thereby eliminating the double tax on operating income, and then the equity of the entities is sold so that we do not have a double tax on the asset sale/distribution by the C corporation? The results change dramatically.

Operating Income 

Operations-Taxable Income with Retained Cash

LLC/S Corp

With QBI Deduction

LLC/S Corp

C Corporation

       

Taxable Operating Income

$1,000,000

$1,000,000

$1,000,000

Qualified Business Income Deduction

($200,000)

   
       

Taxable Income

$800,000

$1,000,000

$1,000,000

       

Ordinary Income/Corporate Tax

$296,000

$370,000

$210,000

Dividend (net after corporate tax)

     

Qualified Dividend Tax

     

Medicare Tax

     
       

Total Tax

$296,000

$370,000

$210,000

       

The net after tax cash flow under this illustration is as follows: 

Operations-Cash Flow with Retained Cash

LLC/S Corp

With QBI Deduction

LLC/S Corp

C Corporation

       

Operating Income Cash Flow

$1,000,000

$1,000,000

$1,000,000

       

Total Tax

$296,000

$370,000

$210,000

       

Net After Tax

$704,000

$630,000

$790,000

       

The lower C corporation tax rate then results in a higher net after tax return.

Sale Proceeds

If we then factor in the sale proceeds analysis (assuming an equity interest sale), the results are as follows:           

Sale of Equity

LLC/S Corp

With QBI Deduction

LLC/S Corp

C Corporation

       

Sales Price

$25,000,000

$25,000,000

$25,000,000

Qualified Business Income Deduction

     
       

Taxable Income

$25,000,000

$25,000,000

$25,000,000

       

Basis Increase for Retained Operating Income

$800,000

$1,000,000

 
       

Capital Gain Tax

$4,840,000

$4,800,000

$5,000,000

Medicare Tax

$919,600

$912,000

$950,000

       

Total Tax

$5,759,600

$5,712,000

$5,950,000

       

The net after tax cash flow under this illustration is as follows:

Sale of Equity-Cash Flow

LLC/S Corp

With QBI Deduction

LLC/S Corp

C Corporation

       

Taxable Sale of Business Cash Flow

$25,000,000

$25,000,000

$25,000,000

       

Total Tax

$5,759,600

$5,712,000

$5,950,000

       

Net After Tax

$19,240,400

$19,288,000

$19,050,000

       

The results are now very comparable given the absence of the double C corporation tax and the shareholder tax on the receipt of the dividend distributions. 

Certain businesses are formed as C corporations to take advantage of the 100% exclusion under Code Section 1202 for qualified small business stock that is held for at least five years. Other businesses are C corporations, or convert to C corporations, at the request of investors. Absent Code Section 1202 or investor driven structure choices, is a C corporation the new preferred entity structure from a tax rate perspective? 

The answer to this question really depends on many factors, including the following: 

  • Is it realistic for the C corporation to retain all cash? Careful consideration needs to be given to the personal holding company tax and the accumulated earnings tax rules. For operating businesses, the personal holding company tax is not normally an issue, but a corporation would need to establish that the accumulation of earnings is not for the purpose of avoiding income tax with respect to its shareholders or risk the imposition of the accumulated earnings tax. 
  • Is it likely that the exit strategy will involve the disposition of stock (typically either a stock sale or some form of merger/reorganization)? A benefit of an S corporation or LLC structure is that the tax results to the selling shareholders/members is typically the same in the case of a sale of equity or a sale of assets. In addition, many buyers prefer an asset sale in order to obtain a basis step up in the assets to reflect the purchase price paid. By comparison, the ability to obtain a basis step up for the assets of a C corporation in connection with a stock sale is more difficult. 
  • The partial return of an investment to a shareholder of an S corporation or to a member in a LLC is more tax-efficient for an S corporation or a LLC than for a C corporation. 
  • The LLC structure currently allows for the non-taxable grant of equity in the form of a “profits interest” or a “carried interest” and this same approach is simply not available for a C corporation. 
  • Converting from a LLC to a C corporation can generally be accomplished on a non-taxable basis, but converting from a C corporation to a LLC is generally taxable. 
  • Converting from an S corporation to a C corporation can also generally be accomplished on a non-taxable basis, but you then typically need to wait 5 years to make an election to convert back from a C corporation to an S corporation. 
  • Is it likely that some of the 2017 Tax Act provisions will be rolled back when there is a change in Congress or the Administration? This happened most recently with the changes made by President Obama (rolling back the Bush tax cuts), so any change in entity structure needs to be evaluated with the thought that the 21% C corporation tax rate might be short-lived.           

As noted above, there are many factors to consider regarding entity choice and we suggest that you talk with your tax advisors before you make an entity selection or change from your current entity type.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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