Will C Corporations Become the New Entity of Choice?
President Trump campaigned on a platform of large tax cuts for businesses. Since his election, tax reform has been one of the most important agenda items for him and Republicans in Congress. A key component of their proposed tax reform is a dramatic cut in the tax rate on C corporations.1 The corporate rate cut was a centerpiece of President Trump’s tax plan during his campaign, of the House Republican Blueprint for Tax Reform released in June 2016 by House Speaker Paul Ryan (R-WI) and House Ways and Means Committee Chair Kevin Brady (R-TX), and most recently, of the Unified Framework for Tax Reform released on September 27 by the “Big Six”—House Speaker Paul Ryan (R-WI), Senate Majority Leader Mitch McConnell (R-KY), Treasury Secretary Steven Mnuchin, White House adviser Gary Cohn, House Ways & Means Committee Chairman Kevin Brady (R-TX), and Senate Finance Committee Chairman Orrin Hatch (R-UT). The Unified Framework, which will be the basis of negotiations on tax reform, proposes a federal income tax rate for corporations of 20%.
The current top corporate tax rate is 35%, and the top individual tax rate on ordinary income is 39.6%. If tax reform passes, and the corporate tax rate decreases below the individual tax rate, there likely will be a significant shift in the type of entity taxpayers choose to conduct businesses.
For years, conventional wisdom has been that taxpayers should form pass-through entities, which include most state-law partnerships, limited liability companies (LLCs) and S corporations. The benefits of a pass-through entity, according to conventional advice, include that business income would be subject to significantly lower taxes than if a corporation were formed. A simple example illustrates this: Individuals A, B, and C form an LLC to conduct their business. When the LLC earns $100 and distributes the income to the members, net after-tax proceeds to A, B, and C will be $60.40 (assuming the income is operating income as opposed to capital gain, and assuming A, B, and C are in the highest individual tax bracket of 39.6%). By contrast, if they form a corporation, when the corporation earns income, it will pay $35 in tax, and distribute the remaining $65. A, B, and C will then pay tax at 20% (the rate applicable to qualified dividends) on the $65, leaving them with after-tax proceeds of $52—considerably lower than the $60.40 using a pass-through entity.2
Sure, you might say that this differential in after-tax proceeds results only because A, B, and C decided to take the earnings out of the entity. If they do not need the earnings, and have the flexibility to leave them in the corporation, then the comparison would be $39.60 in taxes payable with the LLC versus $35 with a corporation (as opposed to $39.60 versus $48 if earnings are withdrawn). But consider that (1) not every business owner can afford to leave earnings inside the entity indefinitely, and (2) upon an exit event, the business owners will almost certainly not want to leave the earnings inside the entity if assets of the entity are sold. That is, if A, B, and C eventually try to sell their business, they will learn that, for tax and non-tax reasons, most buyers want to buy assets of the business rather than ownership interests in an entity. Since a corporation’s income on a sale of assets would be subject to an entity-level tax, whereas an LLC’s would not, the sale of assets using a corporation will result in a significantly higher tax cost to A, B, and C than the use of an LLC. To sum up, under the existing rate structures, in most cases, a pass-through entity is advisable.
If, however, the tax rate on corporate income is reduced significantly below the tax rate on individual income, then we likely will see a shift in the conventional advice. If, as suggested in the Unified Framework, the top individual income tax rate becomes 35%3, the top corporate tax rate becomes 20%, and the existing 20% top tax rate for individuals on qualified dividends and long-term capital gains remains, then the results under our example would be considerably different.
If A, B, and C form an LLC to conduct their business, then when the LLC earns $100 and distributes it to its members, total taxes payable would be $35 (assuming operating income as opposed to capital gain, and assuming A, B, and C are in the 35% bracket). By contrast, if they form a corporation, then when the corporation earns the $100 of income, only $20 in taxes would be payable. Twenty is significantly lower than $35. If A, B, and C do not need to take the earnings out of corporation, then a significant deferral of tax would result for as long as the earnings are left in the corporation. If A, B, and C need immediate cash and therefore withdraw the earnings, they would pay tax on the dividend distribution at a 20% rate—$16 in tax. That would mean total taxes payable of $36—only $1 more than the $35 in taxes payable with an LLC. Add to this mix the possibility that the shares of the C corporation might qualify as “qualified small business stock,” so that gain on the sale of the stock could be entirely tax-free, and the case for using a corporation becomes even stronger.
Why wouldn’t individuals form a C corporation to conduct their business? Under the best case scenario, they will defer considerable tax on business income for years. On a sale, they may be able to negotiate a sale of stock to a buyer,4 and, if applicable, the stock of the corporation may qualify as qualified small business stock. Worst case scenario: they will defer considerable tax on business income for years; if they need cash, perhaps the corporation might lend it to them. They will pay two levels of tax upon an exit from the business—but the two levels would add up to be only slightly higher than the single level of tax applicable to the income if an LLC had been formed.
But what of the possibility left open by the Unified Framework that a lower maximum tax rate of 25% would apply to the business income of “small and family-owned” businesses conducted by individuals and pass-through entities? That is a possibility, and we will have to wait to see the details about when this lower maximum rate to pass-through income will apply. Thus far, the Trump administration has made statements to indicate it will apply in limited circumstances.
One other important point to consider: given the current political climate, tax reform is likely to pass via the budget reconciliation process, rather than as legislation with bipartisan support. One effect of this is that the resulting tax cuts would not be permanent and would expire after 10 years. What would happen if you formed a C corporation, and in 10 years the corporate tax rate once again came to today's levels? Converting to a pass-through entity at that point likely would be quite costly from a tax standpoint in most circumstances. The risk of the rate cuts not becoming permanent is something to carefully consider.
So, should you abandon pass-through entities altogether? Of course not. Even with a dramatic corporate rate cut, there will be many situations in which a pass-through entity will make more sense. The larger point is that, unlike the changes in tax planning we’ve seen from other rate cuts passed through the budget reconciliation process (for example, the Bush tax cuts in 2001 and 2003), if the rate cuts proposed this time become law, there likely will be a much more significant shift in tax planning.
1. Any reference to corporations is to C corporations, which pay an entity-level income tax, unless otherwise specified.
2. This illustration does not factor in state taxes or the net investment income tax of 3.8%, which the Unified Framework does not mention.
3. The Unified Framework mentions the possibility of an additional higher tax rate for individuals —though it is unclear how much higher that rate would be and when it would apply.
4. Notably, if tax rates are lowered for businesses, buyers may value asset purchases less than they do currently. The main tax reason to prefer asset purchases is that they result in a stepped-up tax basis in the purchased assets, and therefore greater depreciation/amortization deductions for buyers. If a buyer’s rate is lower, it follows that the buyer will place a lower value on deductions that would further lower its tax burden.