Tax Reform and a Fresh Look at Business Entity Selection
To “C” or Not to “C?”
As you know, sweeping tax reform was passed into law late last year. This legislation, known as The Tax Cuts and Jobs Act (TCJA), modified both C corporation and pass-through entity taxation.
The pass-through provisions will generally be phased out in less than a decade, but the tax cuts for C corporations are permanent changes to the tax code. The short-term and long-term effects of these changes could make choice of entity determinations one of the most important tax decisions taxpayers will ever make.
Some of the Changes
One of the most impactful changes to the tax code is the reduction in the corporate tax rate. It decreased from 35% to a flat rate of 21% – the lowest it has been since the Great Depression. Not only is this much lower than individual tax rates, but it is competitive with other countries’ tax rates. Pass-through businesses may also see a temporary reduction in their effective tax rates; the highest individual rate will be reduced from 39.6% to 37% through the year 2025. Some pass-through entity owners can further reduce their effective tax rates by utilizing the 20% Qualified Business Income Deduction. Unfortunately, this deduction could be limited or phased-out for certain taxpayers, and will sunset after tax year 2025.
Tax rate reductions are not the only changes business owners must consider. Some other tax code revisions brought forth by the TCJA are as follows:
• The corporate Alternative Minimum Tax (AMT) has been eliminated.
• The individual AMT exemption has increased significantly, subjecting fewer pass-through business owners to this tax.
• Corporations can fully deduct state and local taxes, whereas individuals reporting flow-through income can only deduct up to $10,000 of state and local taxes.
• The net operating losses (NOLs) for corporations can now be carried forward indefinitely, but the two-year NOL carryback is disallowed.
• The NOL carryover for corporations is now limited to 80% of the business’s income.
• Flow-through entity owners can only offset up to $500,000 of business losses against nonbusiness income, and these “excess business losses” must be carried forward.
• The repatriation tax allows multinational corporations to invest their overseas earnings in US activities at low tax rates for a period time – an option unavailable to owners of pass-through entities.
It can be difficult to know for certain which entity formation will be best, but a good place to start is to look at both the return on investment and the long-term effective tax rate of the different entity selection options.
Return on investment (ROI) is a fairly simple calculation: it takes the net gain on the investment divided by the cost of the investment. This number can be heavily impacted by tax liabilities, which is why it is a key performance measure for most businesses. A business’s effective tax rate (ETR) is another good performance measure. ETR is the average rate at which business profits are taxed. Because this calculation is an average taken over time, it can calculate both shorter- and longer-term outcomes, and this insight is especially helpful to assess the impact of tax laws that include sunset provisions.
To calculate these ratios effectively, taxpayers must have clear long-term plans. They will have to consider their state and local activity, international expansion plans, accounting methods, the cost of compliance, projected income, the rate at which they plan to reinvest and/or distribute their earnings, and their long term exit or succession planning objectives.
We recommend that business owners utilize the help of our trusted team of CPAs to help them with this selection process. Taxpayers who utilize the help of WNDE can expect the following three step approach from their team of CPAs:
1. Initial Scoping
The team will review the business’s tax returns, financial statements, projected earnings, and other reports to familiarize themselves with the existing entity structure.
2. Data Gathering & Fact Finding
The team will gather more detailed information to fully understand business operations, owner makeup, and future plans for the company.
3. Detailed Analysis & Modeling
The team will use the information they obtained in Steps 1 and 2 to model the estimated tax impact over a certain period of time under the most viable scenarios.
The best solution for business owners may not be cut and dry; the solution may be to (1) retain the current structure, (2) change the structure, (3) combine or separate existing entities to create new structures, or (4) bifurcate business activities into completely new entities.
To discuss the impact of tax reform, and to get help determining your business’s ideal entity type going forward, please contact your WNDE professionals.