The Tax Cuts and Jobs Act (TCJA) of 2017 reduced the federal income tax rate for C Corps to 21%, effective January 1, 2018. With this tax rate reduction, business owners can assess whether there is a tax advantage in operating activities, such as C Corps. Existing corporations can become a rolling tax entity (i.e., an LLC, Partnership, or an S corporation) for C corps, generally with little or no tax cost. This tax report discusses several considerations that an entrepreneur and their consultants can consider when deciding whether C Corps is preferable.
Flow-Through Entities Historically Preferred.
Most private companies are organized as flow-through entities, including S-Corps, LLCs, sole proprietorships, and partnerships, due to the historically low tax rate applied to distributed profits. The profits of a direct flow company are taxed to business owners at the individual tax rate. Before the 2017 tax law, the highest federal rate per individual was 39.6%. After paying federal and state taxes, homeowners were expected to keep around 55% of their profits (assuming a 5% tax rate). If the business was created as a C corporation, before the 2017 tax law, the effective federal tax rate was 34% of the profits of C corporation, and the maximum federal tax rate for a single dividend shareholder was 20%, which equates to a 3.8% increase in net investment income tax. The C Corps combined federal distributed profit rate was 49.7% [34% + (0.66 x 23.8%)]. After paying federal and state taxes, shareholders of the C Corps could expect to keep around 45% of the profits.
As you can see, the C Corps structure has led to an additional tax rate of 10%. For this reason, LLCs, Partnerships, and Corporations were generally preferred over C Corporation.
2017 Tax Act Rate Changes.
On January 1, 2018, the federal share of C corporation tax was reduced to 21%. Following the C corporate tax rate reduction to 21%, the maximum federal tax rate received by a C company followed by a profit after tax dividend for the shareholders is approximately 40% [21% + ( 0.79 x 23.8%)]. There is no expiration date for the reduced corporate tax rate.
Between January 1, 2018, and December 31, 2025, the maximum federal income tax rate was reduced to 37%. Additionally, the 2017 tax law establishes the new Qualified Business Income Deduction (QBID), which typically gives the business owner a deduction equal to 20% of the net business income. There are limits in the allocation of QBID (for example, some specific service companies are limited or excluded, and there may be limits if certain wages or investments in the activity limits are not reached.
Assuming QBID applies, the maximum effective tax rate on trade flow income for the owner is approximately 30% [37% - (37% x 20%)].
As you can see, the 2017 tax law generally retains the additional 10% tax rate applied to C corporations' distributed profits compared to a streaming entity to which QBID applies. Therefore, there is always a great benefit to selecting a streaming entity, rather than a C company, if the Company is QBID eligible and expects all or a substantial portion of the profits to be distributed to the owners over a while. However, when a substantial portion of the profits should be retained by companies to reinvest or pay off debt, there may be an advantage in the structure of the C Corps.
Will the Corporation's Earnings Be Retained?
If the owners intend to reinvest a substantial portion of the profits into their business to develop them, the C corporation tax structure might have an advantage over a flow-through entity structure, as the profits would be subject to a rated maximum of 21%, up to the declaration of a dividend on the income obtained. Thus, 79% of the profits will be available for reinvestment in the sector.
In the case of a flow-through entity, the profits withheld at source do not generally reduce the overall tax rate, since the profits are taxed to the owners, whether or not distributed. Therefore, the continuing tax rate, assuming QBID applies, is approximately 30%, excluding withholding tax. If the QBID does not apply, the rate will be approximately 37%.
As a result, more retained earnings after taxes can be accumulated in the C Corps to reinvest in the business or pay off corporate debt. Over the years, this "tax savings" can be significant and be a real cash benefit for the C Corps, which may plan to increase reinvestments or a debt settlement strategy.
Accumulated Earnings Tax for C Corps.
As previously noted, C Corps, which distributes the profits to its shareholders, translates into a federal tax rate of around 40%. However, if the profits are retained, the dividend tax for the shareholders is generally avoided until the dividend is paid. Excluding dividends, the corporate tax rate is 21%. However, the Internal Revenue Code limits a C corporation's ability to elect to defer dividends if retained earnings have accumulated more than the reasonable needs of the business. As a result, these excess profits may be subject to an additional "cumulative gains" tax of around 20%.
If C Corps cannot justify the amount of its undistributed income with specific, definitive, and enforceable plans for the use of that undistributed income, the undistributed income tax may be applied to that undistributed income. Therefore, although C Corps has a tax of 21%, this tax rate only applies to the extent that the profits are reinvested in the Company or are necessary for the reasonable needs of the Company, established by the company society in one way or another specific, final and workable plans for the use of these retained earnings. With the true magnitude of future income growth uncertain, it is unclear whether all future income or at least a substantial portion of future income will be required for business reinvestment. Therefore, there is a risk that the business's profits will exceed the capital required to reinvest and pay off the debt. Finally, excess profits may need to be distributed, which will result in a combined federal rate of approximately 40% of distributed profits, as noted above. This risk should be weighed against the expected "tax savings" obtained by deferring the tax on dividends on profits reinvested in the business or used to pay off the business debt. Additionally, as discussed below, in the case of a sale qualifying for Section 1202 processing, the regulatory sales/dividend tax may be avoided.
Tax implications for the future sale of the business
There are tax implications that result from the type of business entity when the business is sold in the future, which should be taken into account when choosing a business entity. From a tax point of view, the sale of shares of C Corps are taxed at a maximum of 20%, plus the income tax rate of 3.8%. Whether C Corps qualifies for Compliant Processing Code. 1202 (as explained below), the shares of Corporate Corporation can be sold without taxable profit, which brings the tax rate to 0%. The sale of a joint-stock company, LLC, or assets or investments in shares (for example, shares, LLC, or investments in stocks) is generally taxed at a maximum rate of 20% without any tax on investment income.
However, there can be barriers to structuring a sell transaction as a sale of stocks, rather than an asset sale, as buyers generally prefer to buy assets rather than stocks. If a buyer is considering a stock purchase, he or she may assign a reduction in the value of the stock relative to the value of the business's underlying assets.
A buyer may require a discount rate due to
The absence of a tax base for the increase in assets when purchasing shares
The risk of undivided debts when acquiring shares. If the sale proceeding is structured as a sale of assets by C Corps, the sales tax's effective rate is approximately 40%, as noted above.
However, Code Section 1202 can lead to a reduction in the tax on a sale of assets by a corporation, eliminating the tax on dividends when shareholders receive the proceeds of the sale in full settlement of the transaction. Section 1202 allows for the exclusion of profits from the sale or exchange of QSB shares; therefore, the sales of C companies' assets are generally not eligible for the Profit Exclusion Code of Section 1202.
However, if the assets of a C company are sold in full, and the proceeds are distributed to shareholders as part of a settlement plan, the transaction will be treated as an exchange of shares per article 331 of the code. Therefore, while a sale of C Corps assets would not normally be eligible for Code 1202 gain exclusion treatment, if the assets of the Company are sold in the complete liquidation, then Code Sec. 1202 would apply and thus reduce the maximum tax rate on the scale from 40% to 21%, this rate is approximately equal to the 20% sales tax rate, as mentioned above.
Therefore, if the Code in Section 1202 applies, a future change in the controlling transaction can be structured as a sale of assets by C Corps to avoid reductions in valuation. A buyer may apply to a company structure for the sale of shares. They also achieve approximately the same tax rate (for example, 21%), which would be if the asset were a continuous flow-through entity. Assuming the Company qualifies for Code Sec. 1202, the conversion to C Corps cannot create a disadvantage in sales tax treatment.
Qualification for Code Sec. 1202 Treatment.
Code Sec. 1202 provides a 100% gain for the exclusion of a shareholder from the sale or liquidation of Qualified Small Business stocks (QSB) that the shareholder holds for five (5) years or more. The exclusion results in a tax rate of 0% of the profit from the sale of QSB shares. QSB shares must meet the following requirements:
Shares are issued after 2010 by C Corps (although a partial income exclusion is available for shares issued after 1993)
C Corps issues the shareholder shares
At least 80% of the Company's assets are used to actively manage an asset for the duration of the holding of the shareholders' shares
At any time before and immediately after issuing shares to the shareholder, the Company's gross assets must not exceed $ 50 million
The maximum for-profit amount is less than $ 10 million or ten times the adjusted capital base of CSQ shares.
Some companies may not qualify as QSB shares, including:
(A) Any trade or activity involving the provision of services in health, law, engineering, architecture, accounting, actuarial services, brokerage services or any trade or activity in which the main activity of that business or activity is the reputation or ability of one or more employees;
(B) Any banking, insurance, financial, leasing, investment, or other similar activity;
(C) Any farming business (including collecting or harvesting trees);
(D) Any business involving the extraction of products of a character whose deduction for depletion is authorized per §613 or §613A;
(E) Any business that operates a hotel, motel, restaurant, or similar business.
Conclusion
For most existing businesses structured as streaming entities and eligible for the 20% deduction for QBI, conversion to C Corps may not be recommended due to the overall 10% benefit on profits distributed to a streaming entity under current law. A similar conclusion can be drawn for new businesses. However, a company that intends to reinvest almost all its profits for several years may consider C Corps an alternative. Another critical factor is whether the shares of C Corps qualify as QSB shares, as QSB shares may incur the same rate of sales tax for C Corps as a streaming entity.
