All pass-through entities, including partnerships and S corporations, should evaluate their choice of entity as a result of tax reform and the new reduced corporate tax rate of 21 percent (previously 35 percent). Converting from a pass-through entity to a C corporation requires thoughtful consideration, analysis, and planning.
WHY CHOICE OF ENTITY?
- The new corporate tax rate of 21 percent is significantly lower than the individual tax rates, now having a maximum rate ranging from 29.6 percent to 37 percent. Because of this difference in tax rates, a C corporation entity should have more after-tax cash available to re-invest, creating incrementally greater value to its owners as compared to a pass-through entity.
- TheÂ effectiveÂ tax rate differential between corporate and pass-through entities has been significantly reduced. This has created an environment where even with two levels of taxation, a C corporation structure may generate greater after-tax cash value to its owners as compared to a pass through entity.
- Companies have a fiduciary responsibility to their shareholders and partners to evaluate their choice of entity given the significant changes outlined in tax reform legislation.
WHAT ARE THE KEY FACTORS TO CONSIDER?
- Taxable Income
Inherent in considerations to structure companies in a tax efficient manner is an expectation that the company plans to generate current and future income that will be subject to taxation.
- Section 199A
The Section 199A Deduction may reduce a pass-through ownerâ€™s maximum individual effective tax rate from 37 percent to 29.6 percent. It is critical to begin evaluating the extent the pass-through owner will be eligible for this deduction as part of the Choice of Entity analysis.
- Future Plans:Â Reinvest or Distribute
The ability to generate incremental revenue and value on reinvested cash favors a corporate entity, due to the lower initial tax liability. Itâ€™s important to evaluate whether a company plans on reinvesting or distributing their after-tax cash, as this may significantly impact the overall effective tax rates.
- Domestic Tax Reform
Impact of other tax reform provisions on the companyâ€™s overall income tax liability may increase the benefits of an entity change. For instance, tax reform changes have affected rules surrounding the amount and timing of income recognition. A company may benefit from these changes via selecting more advantageous accounting methods following a change in entity.
- International Tax ReformÂ
International tax reform has created a number of complexities that may result in significant incremental tax burdens to a pass-through entity as compared to a corporate entity. These potential tax liabilities may significantly impact the overall effective tax rates.
This article originally appeared in BDO USA, LLPâ€™s BDO Knows Federal Tax Alert newsletter (March 2018). Copyright Â© 2018 BDO USA, LLP. All rights reserved. www.bdo.com