C corps may become a bit more popular under
the new regime given the big reduction in their tax rate, but pass-throughs
still seem to have the upper hand, advisers say
Jun
8, 2018 @ 3:44 pm
By Greg Iacurci
The new federal tax law has changed the
calculus around the selection of business entities by financial advisers and
their clients.
Advisers trying to determine whether it's best
to be a pass-through entity or a C corporation under the new regime will find
the answer likely isn't as straightforward as a simple math calculation. The
considerations are complex and may go beyond near-term tax savings to
longer-term questions about future business goals and decisions.
"There are new levels of convolution that
provide opportunity but also confusion," said Leon LaBrecque, managing
partner at LJPR Financial Advisors.
"In the past I told people to go
pass-through, not C corp, for most startups," Mr. LaBrecque added.
"Suddenly, that becomes less prevalent."
Roughly 92% of private businesses in the U.S.
are structured as pass-through entities. Pass-throughs, such
as limited liability companies, partnerships and sole proprietorships, pass
their business income through to their owners' tax returns. Profits are taxed
at the owner's income-tax rate.
The tax law slightly reduced marginal income-tax rates, so taxes on
pass-through business income will automatically be lower for most Americans. In
addition, the law grants a tax break to pass-throughs in the form of a 20%
deduction on qualified business income. Some may not qualify for that
deduction, though, or may get a lesser deduction, because of constraints.
Concurrently, the tax law greatly reduced the
federal tax rate on corporate income — to 21% from 35%.
Despite the significant reduction in the rate
for C corporations, in most cases pass-throughs will still be more efficient
from a pure tax standpoint, said Tim Steffen, director of advanced planning in
Robert W. Baird & Co.'s private wealth
management group.
Unlike pass-throughs, C corporations have a
second layer of tax, which occurs at the ownership level on the income passed
to shareholders as a dividend. (Most will pay 15% or 20%, the top rate.) So the
effective C corp tax rate is somewhere between 32.8% and 36.8% for most
business owners, Mr. Steffen said.
That doesn't compare favorably with
pass-throughs, since the tax rates for those business owners would likely fall
between 22% and the top 37% rate.Nor does that comparison factor in the
additional 20% deduction many pass-throughs will get.
"The gap has been narrowed some,
especially for businesses that don't qualify for the 20% exclusion," Mr.
Steffen said. "For those that do qualify, they still have a real advantage
over C corps."
OTHER FACTORS
However, there are several additional factors
to consider that could tilt the scales.
State taxes are one. While taxpayers used to
be able to deduct all their state and local taxes, the new law caps the deduction at $10,000 for state income, sales
and property taxes.
That means "many individuals will no
longer receive a federal benefit for state taxes paid as a result of their
allocable share of pass-through income," according to a Deloitte report
about entity conversion published Thursday. However, state taxes are still
fully deductible by C corps.
C corporations also may make more sense for
certain kinds of wealth accumulation, Mr. LaBrecque said.
For example, what if the owner of a C corp
plans to retain all earnings for future investment in the business? If 100% of
the income is retained, the effective tax rate for the C corp is 21% — the
second layer of tax on dividends wouldn't apply.
That rate would be 16 percentage points lower
than the 37% rate paid by the wealthy owner of a pass-through business. Even if
this owner were to get the 20% pass-through deduction, the individual's
effective tax rate would be 29.6%, which is still 8.6 points higher than the C
corp rate in the prior scenario.
Conversely, if an owner needed more cash from
the business, the owner would be more likely to remain a pass-through since
that cash would be double-taxed in a C corp, said Wolfe Tone, a partner in
Deloitte's tax group.
Estate planning may also factor into this
calculation, Mr. Tone said, noting that many estate plans require cash to be
distributed out of a business to facilitate estate-planning structures like
trusts.
Moreover, a C corporation may not be the best
choice if the owners plan to sell the business in the foreseeable future,
according to the Deloitte report. If assets are sold in a C corp, the gain is
double-taxed — once at the corporate level and again when profits are
distributed to shareholders. With a pass-through, though, sellers wouldn't be subject
to two tax layers.
"In the old days, we tended to ask
[clients], 'What happened?' Now we have to ask, 'What will or might
happen?'" Mr. LaBrecque explained of the shift in planning required by the
tax law. "The forward-thinking advisers will have gigantic
opportunities."
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