One of the perennial questions faced by taxpayers when forming a business is whether to incorporate it as a C Corporation or to form a flow-through entity such as an LLC, partnership, or S corporation. For most small business owners, the choice thus far has been a simple one: unless non-tax related considerations weighed heavily in favor of a C corporation – e.g. ease of raising capital, centralized control, etc. – small business owners almost always favored a pass-through entity. A pass-through entity generally does not pay “entity level” taxes – and all tax consequences ‘pass-through’ to the individual owners or members in pro rata shares. A Corporation, on the other hand, first pays income taxes just as an individual would, and then the shareholders pay another tax on the same income when it is distributed to the shareholders as dividend – to the extent of Earnings & Profits. As one can imagine, the double taxation packed quite a punch when the corporate tax rate and the highest individual income tax rates were almost on par.
However, the Tax Cuts and Jobs Act of 2017 (TCJA), dropped the corporate tax rate precipitously from a maximum rate of 35% to a flat rate of 21%, while the individual income tax rate was lowered more modestly from 39.6% to 37% (at least until 2025, when it is set to expire altogether. The corporate flat tax rate is permanent). In addition, the TCJA left intact the maximum 20% rate for qualified dividends.
In practical terms, this translates into major tax savings and income sheltering opportunities for high income taxpayers. Suppose that a corporation earns income of $100 in a given year. After paying the flat corporate tax rate of 21%, it has $79 available for distribution. The distribution triggers a tax of $15.80 ($79 x 20%) and leaves the shareholder with $63.20 after tax. Thus, under the current law the maximum combined burden on distributed corporate earnings is 36.8% – which is lower than the maximum individual rate of 37%. This provides an incentive for high income taxpayers to shelter their money in a C corporation without suffering the full brunt of pre-2017 double taxation.
A C corporation may still not make sense for many business owners who qualify for §199A deduction – congress’ parallel gift to pass-through entities (albeit a temporary one, as it expires in 2025). §199A provides a 20% income tax deduction for many sole proprietorships and pass-through entities. This deduction has many exceptions and qualifiers; help from a tax professional is necessary to determine whether you qualify for it and how much you qualify for. However, if you do qualify for the full tax deduction, your tax rate is effectively lowered to a maximum rate of 29.6%.
In sum, while the TCJA makes C corporations much more attractive by drastically reducing the tax rate, a pass-through entity may still make more sense to some business owners who qualify for a part or all of §199A deduction.