Tax Reform: The New C Corporation Tax Rate and Whether to Reorganize as a C Corporation

The Tax Cuts and Jobs Act passed Congress on December 20, 2017 and was signed into law by the President on December 22, 2017 (the enactment date) and is generally effective for tax years beginning after 2017.  This is the fifth in a series of articles reviewing some of the more important changes.  This post deals with the new 21% C corporation tax rate and whether businesses should reorganize as C corporations to take advantage of the new low tax rate.

Overview of the New 21% Tax Rate

Corporations are divided into two basic income tax classifications: “C” and “S”.  A corporation will be taxed as a C corporation unless it has made an election, approved by the IRS, to be taxed as an S corporation.  A C corporation pays income tax on its taxable income and its shareholders pay tax on the income only when the C corporation pays dividends.  The shareholders of an S corporation pay income tax on the S corporation’s taxable income and generally do not pay tax on dividends from S corporation profits.  C corporation shareholders economically bear a double income tax:  once at the corporate entity level and again on dividend distributions.  S corporation shareholders bear a single tax.  An S corporation is often referred to as a “pass-through” or a “flow-through” entity because only one level of tax is paid, and that responsibility passes or flows through to the shareholders.

The new law replaces the current four C corporation tax rate brackets of from 15% to 35% with a flat tax rate of 21% for tax years beginning after 2017.  C corporations with fiscal tax years ending other than on December 31^st will have a prorated tax rate.  The tax of a fiscal year filer is computed twice, once using old law rates and again using new law rates.  The two taxes are then prorated by the number of days in the fiscal year before the January 1, 2018 effective date of the new law and the number of days in the fiscal year after December 31, 2017.  The calculation works out to be roughly a 1.17% monthly effective tax rate increase above 21% for each month in the fiscal year prior to January 1, 2018.

Under the new law, there is no special higher tax rate for personal service corporations, but the personal holding company and accumulated earnings penalty taxes still apply.

Should You Reorganize Your Pass-Through Entity or Proprietorship as a C Corporation?

While the low 21% C corporation rate looks attractive, adding a state corporate tax rate (5% for Utah) plus the cost of double taxation on distributed earnings quickly makes for a high effective overall tax rate.  Assuming a top shareholder qualified dividend or long-term capital gain tax rate of 20%, a net investment income tax (under the ACA) rate of 3.8%, and a (Utah) individual tax rate of 5%, the combined effective tax rate on distributed after-tax C corporation earnings is 46.6%.

The 20% qualified business income deduction was discussed in a prior post.  If all the income is eligible for the deduction, the combined federal and state effective top tax rate for income of a pass-through entity is 33.6% for an owner who materially participates in the business, or 37.4% for a passive owner, the difference being the 3.8% NIIT.  Without the 20% QBI deduction (e.g., income is from a specified service business), the effective tax rate rises to 42.0% and 45.8% depending upon the owner’s level of participation in the business.

For businesses qualifying for the 20% QBI deduction, it appears that remaining a pass-through entity is the preferred choice.  However, other factors enter into the decision.  Will the entity reinvest profits to grow the business or to pay down debt?  If so, the C corporation will have less current tax.  On the other hand, will profits be distributed to owners or will the owners sell their interests in the future?  If so, then the pass-through entity will have less overall tax.  In addition, if the business won’t distribute profits or be sold for years into the future, the present value cost of the double tax can be dramatically lowered depending upon the present value discount rate.

For specified service businesses that don’t qualify for the 20% QBI deduction, there may be ways to restructure the business to carve out a portion of the business into a separate entity that qualifies for the deduction.  The balance of the service business then might consider becoming a C corporation.  Before undertaking such a reorganization, it is advisable to wait for official guidance from the IRS as to how it will apply rules to related party carve-outs.

Making the decision to reorganize as a C corporation requires careful analysis of many factors.  One factor that must be considered, but which can’t be quantified, is the risk of a future Congress changing the tax rules again in a manner detrimental to those who have reorganized as C corporations.