Tax reform gave C corporations an eye-popping tax break by dropping their rate to a flat 21% — from up to 35%. Owners starting up a small business are tempted, but should consider carefully which type of entity they want.
A lot of small or midsize businesses used to be advised that they should be sole proprietors or set up as pass-through entities, like one of these:
- A single member LLC is treated as a sole proprietorship for tax purposes
- A partnership
- An LLC taxed as a partnership
- An S corporation
When the owner of a C corporation takes the money out of the business, a certain portion of the profits may be taxed twice, once as corporate profits, then again as a distribution to the owner. This can be costly.
Shareholders in C corporations are taxed on dividends and capital gains. Pass-throughs pay no federal income tax at the entity level.
C corps’ tax rate is lower now, but the double tax still exists. Some owners of small businesses will want to go C but there are still advantages to pass-throughs and sole proprietors.
The new tax law gave pass-through entities a goodie: up to a 20% deduction on qualified business income, or QBI. In some cases, this may mean pass-throughs remain better than C corps for small businesses.
Three Common Scenarios
So should you set up a C corp to get the huge tax break? There’s no one-size-fits-all answer. Your choice depends on what your business is, and what the owners are like. Three common scenarios are below.
The business doesn’t do well for a long time and loses money. The losses go in, but C corp owners can’t deduct them. So there’s no tax benefit.
So, you’d probably still do better with a pass-through or sole proprietorship. Pass throughs can take the loss. It goes on your personal return, on Schedule C, E or F.
You’re the owner of a small or medium-sized company. You make a profit. You don’t have losses. And you pay all the profits to the owner. Let’s compare a pass-through (sole proprietorship, partnership, LLC taxed as a partnership, or S corporation) with a C corporation.
The C corporation pays its 21% tax. Then it pays out the rest as a dividend.
A dividend is subject to a 20% top rate plus the 3.8% net investment income tax. Run the math and the effective federal tax is 39.8% on the top. 21% plus (20%+3.8%) times (100% - 21%).
Yes, C corps’ rate went down, but then add the double tax. Still, if you are the owner of a C corp and you pay it all to yourself, the top rate is 39.8%, much lower than what you would have paid before tax reform.
But if you’re the owner of a pass-through and you pay it all out, the top rate is 40.8%.
That’s the 37% top rate for individuals plus the 3.8% NIIT or the Medicare part of self-employment tax (assuming you pay the extra 0.9% Medicare tax). 37% plus 3.8% = 40.8%. Compare that to the 39.8% effective rate for C corporations. It seems like a small difference.
However, if you’re the owner of a pass-through entity that qualifies for the full 20% deduction, the top rate for you would be 33.4%. Here’s why: take the 37% top rate for individuals and multiply it by the percentage of income that remains after the 20% QBI deduction: (100% - 20%) and add the 3.8% NIIT to that product. (37% x 80%) + 3.8% = 33.4%.
Pass throughs are the likely choice if there are significant QBI deductions. Otherwise, it is a close call, though a C corp may be simpler.
You own a small or medium sized company. You don’t have losses and you keep all the profits in the business to fund growth. Let’s compare a C corporation with a pass through.
Assume that each dollar kept in the C corp increases its share value by a dollar. Later, those shares are sold and taxed at 20% top long-term capital gain rate.
Add it all up and C corp owners get hit with an effective tax rate of 39.8%. Here’s why: 21% corporate tax plus (20% + 3.8% NIIT) times (100% - 21%).
It’s still double, but much lower than before the law changed. And for shareholders in the C corp, there’s no tax until the shares are sold.
If you own a C corp with QSB stock, which is a C corp that meets certain conditions, you may get a full exclusion from tax, making the effective tax rate 21%. If you own a small C corporation or your business is eligible to become one, you might want to have a conversation with your advisor about this now.
Same example, pass through owners get to retain 100% of the earnings, just like C corp shareholders. The top tax rate on that dollar is 40.8%.
It’s the 37% top rate for individuals plus the 3.8% NIIT or the Medicare part of self-employment tax. That’s slightly above C corps’ 39.8% top effective rate.
When comparing pass-through entities with C corporations, owners should ask which is more important to them - having to pay tax on the income now or having to pay tax on the income later. Pass through owners pay tax the year the income is reported. C corp shareholders pay tax later, when shares are sold.
Plus, if the pass-through is eligible for the new 20% deduction for qualified business income (QBI), the top rate is 33.4% because that’s the 37% top rate for individuals times (100% - 20%) plus 3.8% NIIT. Compare it to the 39.8% top effective rate for C corps.
If QSB stock rules apply, a C corp would likely come out ahead. Otherwise C corp likely is better unless large QBI deductions are in play.
Weigh the pass through deduction against the C Corp 39.8% effective tax rate. Talk it over with a tax advisor.
More Tax Factors to Weigh
With taxes in play as they are, the type of entity that a small or midsize business adopts will play into tax planning and tax-saving opportunities, so they’re worth factoring into any decision.
When it comes to fully expensing business equipment, C corps and pass throughs are equal. Section 179 expensing for tangible property is now permanent.
Businesses that buy a lot of equipment may save a bundle on taxes. But for pass-through owners there’s a twist — less income from depreciation reduces the QBI deduction.
Closely held C corps can skirt double tax by paying owners generous salaries and bonuses that are deductible.
The catch: owners are expected to pay themselves reasonable compensation for the services actually provided.
The tactic looks somewhat better now. Owners’ salaries will be taxed at a lower individual rate. Money left in the C corp will only be taxed at the 21% rate.
A C corp has another little break that a pass through lacks - some tax-free fringe benefits for owners who work for the company.
There’s a reverse move that’s also popular: taking as little salary as possible to keep Social Security and Medicare taxes down. People who own S corporations do that.
The IRS knows about this trick and owners who pay themselves a lower salary could be asked to provide proof of reasonable wages. Beware.
Tax reform made the low-salary strategy more attractive for many firms because the IRS treats more of the S corp income as QBI. It doesn’t include reasonable salaries that owners are paid or guaranteed payments that partners receive in QBI. No QBI, no deduction.
What does count? Your S corp net income after deducting what owners are paid in salaries counts.
C corps may pay less tax now, but they also create double tax, which can be unwise if you own appreciating assets like real estate or certain intangibles in the company.
Why? When the C corp sells the appreciated asset, a tax is triggered on the gain at the business level. Then when the cash is paid to shareholders, they may be taxed again.
Pass-through entities aren’t taxed twice on the gain, just once. The top rate is generally 23.8%, but with real estate, it can get ugly. Real estate held in a pass-through may result in a 28.8% top rate on gain tied to past depreciation.
One of the biggest advantages for pass-throughs under tax reform is the new 20% deduction for QBI. There’s a downside that may wipe it out for doctors, lawyers and some other personal services businesses.
These owners can try to get around the limitation on the QBI deduction by putting the non-personal service activity into a separate pass through whose income may count as QBI.
It may not be worthwhile to restructure. Check with an advisor.
Structure a Business Now for Long-term Tax Efficiency
The Tax Cuts and Jobs Act hit everything at once, with changes affecting businesses large and small, in ways that last years. Talk to a tax advisor about how to structure a business now for long-term tax efficiency.
This article talks mainly about start-ups for simplicity’s sake. But for small business owners, C corp, S corp or passthrough should be a current consideration, not just at start-up.
Trying to switch from one business entity to another is a bit like playing hopscotch. There are a number of steps to take, some with extra fees and tax rules. Work with a tax professional if you’re thinking about making a switch.
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