Choosing the best business entity structure post-TCJA
For tax years beginning in 2018, the Tax Cuts and Jobs Act (TCJA) created a flat 21% federal income tax rate for C corporations. Previously, the tax rate on C corporations was as high as 35%. The TCJA also reduced individual income tax rates, which apply to sole proprietorships and pass-through entities, including partnerships, S corporations and typically, limited liability companies (LLCs). The top rate, however, dropped slightly, from 39.6% to 37%.
On the surface, that may make choosing C corporation structure seem like a no-brainer. But there are many other considerations involved.
Conventional wisdom
Previously, many believed most small businesses should be set up as sole proprietorships or pass-through entities to avoid the double taxation of C corporations (a C corporation pays entity-level income tax and then shareholders pay tax on dividends and potentially capital gains when they sell stock.) Pass-through entities pay no federal income tax at the entity level.
Current Considerations
Although C corporations may still have the double-taxation issue under the TCJA, their new 21% tax rate helps make up for it. However, another provision of the TCJA allows noncorporate owners of pass-through entities to take a deduction equal to as much as 20% of qualified business income (QBI), subject to various limits. Currently, the break is available only for tax years beginning 2018 through 2025.
There’s no one-size-fits-all answer when deciding how to structure a business. The best choice depends on your business’s unique situation and your situation as an owner.
3 common scenarios
Here are three common scenarios and the entity-choice implications:
- Business generates tax losses. There’s no tax advantage operating as a C Corporation if your business consistently generates losses. C corporation losses can’t be deducted by their owners. A pass-through entity generally makes more sense because losses pass through to the owners’ personal tax returns.
- Business distributes all profits to owners. For a profitable business that pays out all income to the owners, operating as a pass-through entity is usually better if significant QBI deductions are available. If not, it’s probably a toss-up in terms of tax liability.
- Business retains all profits to finance growth. For a business that’s profitable but holds on to its profits to fund future growth strategies, operating as a C corporation is generally advantageous, if the corporation is a qualified small business (QSB). A 100% gain-exclusion may be available for QSB stock sale gains. If QSB status is unavailable, operating as a C corporation is probably preferred — unless significant QBI deductions would be available at the owner level.
Many considerations
These are only some of the issues to consider when deciding what type of structure is the best choice for your business. We can help look at all of the factors and evaluate your options.
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