We discussed recently a brief overview of the new tax rate changes for both corporations and individuals, as well as the new pass-through deduction of Internal Revenue Code Section 199A. (Read here) Now we want to look a little more closely at how this changes the landscape of available entity choices and the resulting potential tax effects. Let’s examine a few examples. For simplicity, we will ignore self-employment tax and state income tax; we will also assume the highest applicable income tax rates.
Under tax law through 2017, an individual paid income tax on pass-through earnings (including sole proprietorship business income) at a maximum rate of 39.6%. If that same business was conducted in a C corporation, the entity itself paid tax at a maximum rate of 35%, reducing to 65% of the before-tax cash it could distribute to its owners. That amount would be taxed at a maximum qualified dividends rate of 20% (based on certain assumptions), plus 3.8% net investment income tax, resulting in an aggregate effective income tax rate of approximately 50%, an approximate 10% rate difference when comparing a pass-through structure to a C corporation structure.
Under 2018 law, assuming the pass-through limitations previously discussed do not apply, there would be a 20% deduction against the qualified business income (“QBI”), resulting in only 80% of the income being taxed, and that at the new top marginal rate of 37% (again assuming top rates apply to our hypothetical taxpayer). Interestingly, this hypothetical, oversimplified example would yield an effective tax rate on the pass-through income of 29.6% (80% x 37%), exactly 10% lower than the rate under 2017 law. Consider how that compares to a C corporation, now applying 2018 law. The corporate tax rate is only 21%, leaving 79% of the before-tax income to be distributed to shareholders. As the capital gains and qualified dividend rates are not changed under new law, the same net 23.8% (maximum rates) would apply to that dividend, yielding an aggregate effective income tax rate of approximately 40% – roughly a 10% drop, coming close to mirroring the pass-through savings.
This means that, in absolute terms, the tax benefit gap between pass-through structures and C corporations has not changed much at the top rates, though there is a significant tax savings in each category. This is assuming, in addition to the applicability of the top rates, that the Section 199A pass-through deduction is fully available (i.e. all income is QBI) and not limited. In contrast, if the enterprise is a nonqualifying service business with all owners’ taxable income above the thresholds below which the deduction would be allowed, the benefit gap between C corporations and pass-throughs narrows significantly. C corporation shareholders still see the approximate aggregate 10% tax rate drop (to approximately 40%), while owners of pass-throughs only see benefit based on the drop in the top individual marginal rate (2.6% – from 39.6% to 37%), leaving only about a 2.8% rate difference in the two structures.
Of course, as has been mentioned several times already, a number of broad assumptions are made for this simple analysis, including applicable tax rates, immediately distributed income, etc. The facts and circumstances of every business and individual taxpayer differ, so there is no one answer – or comparative analysis – that applies to everyone. There are several other interesting discussions to be had about the income limitations and excludable service activities, but we will cover those separately. The point is this: the landscape between and among competing structural options has changed significantly.
Now, more than ever, thanks to these and many other significant tax changes, the advice of a knowledgeable and skilled tax advisor is advisable.
Next time, we will look more closely at how Section 199A qualified business income is defined and limited, including discussions of reasonable compensation, wages, differing pass-through structures, and specified service trades or businesses.
Michael A. Carraway, Jr., CPA
Michael A. Carraway, Jr., is a partner with GranthamPoole PLLC and a recognized leader in the field of partnership and corporate taxation, having worked with many clients on entity and transaction structuring matters. He has also written, taught, and spoken on many topics in the area over the years and has served as a technical subject matter expert in several practices. Please contact Mike at firstname.lastname@example.org, www.linkedin.com/in/michaelcarraway, or 601-499-2400. CPA License # R2705
***The above does not represent tax advice. Each situation is fact-dependent, and you should seek the advice of a competent advisor. GranthamPoole PLLC is a provider of tax, accounting, advisory and strategic services, partnering with clients across a broad spectrum of industries and sizes.