Lower tax rates under the recently enacted federal tax overhaul in 2017 may have you considering changing your entity structure. However, determining the structure that works best for your particular situation and goals involves balancing many more factors than just tax rates.
As before the new tax legislation, size makes a big difference in entity selection. Small organizations – particularly those with gross income under $1 million – typically benefit the most from an S corporation structure. Small C corporations may not be subject to the full 39.8 percent tax rate because the dividend distributions could fall beneath the net investment income tax threshold, or NIIT, but rates would still likely be around 31 percent. Partnership effective tax rates are generally slightly higher than S-corp rates, due to self-employment taxes.
Differences between effective tax rates narrow slightly as organizations get larger. Organizations may have effective tax rates closer together because owners may not be subject to the top individual tax rate or the NIIT.
Another factor is the type of business you operate. One of the key audiences that may be looking at making an entity structure change are pass-through entities that are ineligible to receive the qualified business income deduction under Section 199A. The law defines qualified business as any trade or business other than: one involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing or investment-management services, or any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners; or one involving the performance of services as an employee.
These so-called service organizations, particularly those with large business taxable income, may benefit more from the C-corp structure. For example, a business with $4 million in taxable income that pays out $2.5 million in dividends would have a lower C-corp effective tax rate than an S-corp or partnership because the service organization could not use the Section 199A qualified business income deduction.
Other considerations about whether to restructure your business remain unchanged:
• Business owners who want to reinvest the majority of their earnings into their business may want to take a look at the C-corp structure. If owners are planning to exit their business in the near term, switching to a C-corp would not be as ideal because of the double taxation issue.
• Companies that want to expand their number of shareholders – perhaps because of growth opportunities or in an attempt to go public – may want to switch to a C-corp to avoid the S-corp limit on the number of shareholders.
• C-corps are also able to issue more than one type of stock as part of their stock compensation plans, whereas S-corps are not. Another item to consider would be the potential exclusion of capital gain on the sale of C-corp stock that qualifies under Section 1202.
Leigh Nali is a managing director at CBIZ & MHM New England, with offices in Providence, Boston and nationwide.
