Choice of Entity Implications of the New Tax Act

Choice of Entity Corner

April 1, 2018
Journal of Passthrough Entities (March-April 2018)

Adam J. Tutaj

Introduction

On December 22, 2017, P.L. 115-97, originally branded “The Tax Cuts and Jobs Act” (the “Act”), was enacted into law.1 The Act was passed through “budget reconciliation”—a process whereby spending and revenue legislation can be passed by a simple majority in the Senate without the risk of filibuster.

The trade-off of using budget reconciliation, however, is the need for any legislation passed in this fashion to satisfy a host of procedural requirements—not the least of which is that it not increase the long-term deficit. In this case, while the Act provides for something on the order of a $1.5 trillion net tax cut within the 10-year budget window, it cannot result in a net tax cut in any year outside that 10-year window without a corresponding reduction in spending.

Because of limits on what can be achieved through budget reconciliation, there is a legitimate question as to whether the Act represents actual “tax reform” or just a “tax bill.” However, this is likely to seem a purely academic question through at least December 31, 2025 (when many of the Act’s provisions will “sunset” in order to attain compliance with the procedural requirements of reconciliation). Moreover, some of the revisions—particularly the reduction in the corporate tax rate—are set to be permanent and will have particular influence in the area of “choice of entity” for the foreseeable future. This column will summarize the key provisions impacting the choice of entity calculus and analyze their impact in this context.

C Corporation Revisions

Perhaps the most notable change—certainly the one that has garnered the most headline attention—is the permanent reduction in the corporate income tax rate. C corporations are now subject to a flat 21% income tax rate regardless of income.2 Gone is the eight-bracket structure, which applied a 35% rate for corporations having $10,000,000 or more of taxable income, and even applied a 39% rate to corporations having taxable income between $335,000 and $10,000,000. Also gone is the special 35% rate applied to “personal service corporations,” which will also enjoy the new flat 21% rate. These provisions are not slated to “sunset” at the end of 2025—unlike a number of other provisions under the Act.

Individual Income Tax Revisions

Individual rates retain their current seven-bracket structure, but the top individual income tax rate was reduced from 39.6% to 37% and the income brackets themselves are higher. The top rate now starts at $500,001 for single filers (as opposed to $426,701) and $600,001 for married filing joint (as opposed to $480,051).3 This new rate structure is effective for tax years beginning in 2018 but will revert to its pre-2018 levels after December 31, 2025.4 Offsetting these benefits, however, are a variety of limited or suspended individual deductions, most notably (i) a temporary $10,000 limitation on itemized deductions for state and local taxes,5 (ii) a temporary suspension of miscellaneous itemized deductions subject to the 2% floor (ameliorated somewhat by the corresponding suspension of the overall 3% “Pease” limitation on itemized deductions),6 and (iii) a permanent limitation on deductions for home mortgage interest and a temporary suspension of deductions for interest on home equity debt (in each case subject to certain “grandfathering provisions”).7

Passthrough Entity Revisions

While C corporations were clearly favored as regards the tax benefits of the Act, passthrough entities (and sole proprietorships) were not completely ignored. This is largely due to the good offices of Senators Ron Johnson (R-WI) and Steve Daines (R-MT), who conditioned their support on securing some measure of relief for passthrough entities and sole proprietorships.8 However, the resulting provision is nowhere near as clear cut as a simple rate reduction. New Code Sec. 199A provides a 20% deduction for certain “qualified business income” from partnerships, S corporations or sole proprietorships (including single member LLCs).9 “Qualified business income” is defined generally to include the net income arising from the conduct of a domestic trade or business, with a number of exceptions.10 Additionally, “qualified business income” does not include reasonable compensation, any guaranteed payments or, to the extent provided in regulations, any payment described in Code Sec. 707(a) to a partner for services rendered with respect to the trade or business.11 Where a taxpayer is eligible to claim the full 20% deduction under new Code Sec. 199A, the effective top rate of such passthrough income is 29.6%.12 The deduction under new Code Sec. 199A is subject to limitations based on the individual’s income. For individuals having taxable income over the threshold of $157,500 single/$315,000 married filing joint, the deduction may be limited to the greater of (a) 50% of the W-2 wages paid with respect to the trade or business or (b) 25% of the W-2 wages paid with respect to the trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of certain qualified property.13 (Such limitation only partially applies to the extent taxable income exceeds the foregoing threshold amounts by $50,000 single/$100,000 joint.)14 While the term “qualified business income” generally excludes certain specified service trades or businesses (e.g., medicine, law, and accounting—but not engineering or architecture), a passthrough from such a trade or business will be treated as qualified business income for individuals having total taxable income under the threshold of $157,500 single/$315,000 married filing joint. Moreover, a phased-out deduction is likewise available to a “specified service trade or business,” if the taxpayer’s income is under the threshold of $207,500 single/$415,000 married filing joint. Individuals having income over these thresholds receive no deduction for such specified service trade or business income.15

No Change to Net Investment Income Tax

Notably, the 3.8% net investment income tax was left unchanged. Accordingly, this will still apply to all C corporation dividends received, as well as passive income earned by individuals in the higher brackets. However, the continued application of the net investment income tax will be most keenly felt in the “sale” context—as the owner of a passthrough entity who is materially participating in the business can avoid the 3.8% tax, whereas the owner of a C corporation cannot.16

Looking at the Act in Context

So how does the choice of entity calculus change after the Act? Let’s take a look at an example to see how various entity forms will compare—at least for years 2018 through 2025, inclusive—in terms of both annual operations and upon a sale of the entity (see Table 1).

Assumptions are as follows:

  • Owners in top tax bracket, over Code Sec. 1411 FICA/SE tax threshold, active in business (non-trading) and paid reasonable compensation;
  • Exemptions fully phased out, itemized deductions still reduced;
  • Entity-level earnings: $1,000,000;
  • Not a personal service corporation or otherwise engaged in a “specified trade or business” within the meaning of new Code Sec. 199A(d)(2);
  • Partnership income subject to self-employment tax;
  • No basis at entity or owner level;
  • No Code Sec. 1202 stock, but long-term capital gain;
  • No state income tax; and
  • Owners qualify for simplified calculation of net investment income under Reg. §1.1411-7(c) ($10,000 portfolio income, $990,000 trade or business income in each of last three years).

Now, in our example, the owners are all in the top tax bracket (viz., over $500,000 single/$600,000 married filing joint)—so the deduction under new Code Sec. 199A would be equal to the greater of (a) 50% of the W-2 wages paid with respect to the qualified trade or business or (b) the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property.” Here, the type of passthrough entity used could make a difference—as W-2 wages would be available to S corporation owners, but not partners or sole proprietors.

The overall tax rate on an additional $100,000 of income treated as a dividend out of a C corporation (39.80%) is markedly lower than before the Act (which would have been a little over 51% on account of both the higher initial tax rate, the imposition of the second-level tax on dividends (including the “Pease” limitation) and the imposition of the net investment income tax). Indeed, in the absence of any deduction under new Code Sec. 199A, we see that the C corporation rate is now lower than in a partnership or sole proprietorship context where the additional $100,000 is subject to self-employment tax. However, in this particular example, an S corporation paying out this additional $100,000 as a distribution still does slightly better under the new 37% rate at the individual level—again, even before the application of Code Sec. 199A (see Table 2).

Assumptions: Same as above, but now entity is sold for $10,000,000.

Prior to the Act, a C corporation in this setting would have absorbed an initial corporate income tax of 34%, rather than the flat 21%. However, because the double tax remains, the passthrough form still has a significant advantage over the C corporation form when it comes to a disposition of the business.

Conclusion

Starting this year, a C corporation can yield income tax results that are comparable to (and, in some cases, slightly better than) the various passthrough forms with respect to annual operations—at least at the top margins. However, if a profitable sale of the enterprise is a possibility, the passthrough form is likely to be superior. Additionally, with the elimination of the special “personal service corporation” rate, services businesses in particular may want to revisit the issue of C corporation status—on account of the fact that such businesses are generally susceptible of lower enterprise values for a host of reasons—including relatively modest fixed assets and ability to separate “personal goodwill” from the equation. This may be particularly true for law firms.17

Endnotes

1 While the House had passed the tax bill with the short name of “The Tax Cuts and Jobs Act,” the Senate parliamentarian ruled that this violated the “Byrd rule” because changing the title from its original long name did not have a budgetary impact (www.cnn.com/2017/12/19/politics/tax-bill-name-delay/index.html). Thus, the official name is: “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.” Not nearly as snappy, but it does what it says on the tin.
2 See Act at Section 13001 (amending Code Sec. 11).
3 See Act at Section 11001 (amending Code Sec. 1).
4 The Act also changes the method for indexing the tax rate thresholds to use so-called “chained CPI”—a modified form of the consumer price index, which takes into account the preference for cheaper goods during periods of inflation and, as such, will typically yield smaller increases to the indexed amounts. This new indexing method is not subject to the 2025 sunset. See Act at Section 11002.
5 See Act at Section 11042 (amending Code Sec. 164).
6 See Act at Section 11045 (amending Code Sec. 67) and Section 11065 (amending Code Sec. 68).
7 See Act at Section 11043 (amending Code Sec. 163(h)(3)).
8 See Kristina Peterson, Sen. Steve Daines to Support the Tax Bill After Securing Pass-Through Change (www.wsj.com/livecoverage/ tax-bill-2017/card/1512131873).
9 See Act at Section 11011 (amending Part VI of subchapter B of chapter 1 to add new Code Sec. 199A).
10 See Code Sec. 199A(c) and (d).
11 See Code Sec. 199A(c)(4).
12 37% × (1 − 0.20) = 29.6%.
13 See Code Sec. 199A(b)(2).
14 See Code Sec. 199A(b)(3).
15 See Code Sec. 199A(d)(3).
16 See Reg. §1411-6(a).
17 Rule 5.6(a) of the American Bar Association’s (“ABA”) Model Rules of Professional Conduct broadly prohibits agreements that restrict the rights of lawyers to engage in the practice of law after they terminate relationships with a law firm or an employer. This rule (some version of which has been adopted in all States) essentially prohibits non-competes and, as such, greatly reduces the “enterprise goodwill” value relative to service businesses that do permit such restrictive covenants.

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