By: Matt Chodosh
This article analyzes the 2018 changes to the tax code, and how they may impact taxpayers’ choice in selecting a business entity. There are many factors to consider when selecting an entity, such as asset protection, personal liability, tax minimization, profit maximization, transferability. This analysis focuses exclusively on tax minimization and tax liability regarding business formation and operations. Taxpayers are advised to seek the advice and counsel of qualified tax practitioners in determining which entity to form.
Beginning in 2018, Individuals are taxed on their ordinary income at a top statutory rate of 37%. IRC § 1(a). In contrast to the old top statutory rate of 39.6% in 2017. C-corporations are taxed at a flat 21%, down from 35% in 2017. IRC § 11(b)(1). Further, the dividends received deduction for dividends from unaffiliated domestic corporations is reduced from 70% to 50%, resulting in dividends being taxed to the payee corporation at 10.5% rate. IRC § 243(a)(1). Finally, taxpayers may be able to deduct 20% of “qualified business income” earned through a partnership, limited liability company (‘LLC’), S-corporation or sole proprietorship. IRC §199(a).
These changes incentivize taxpayers to avoid tax at the top individual rates and take advantage of lower, preferential rates offered with a C-corporation or pass-through structure. In some cases, pass-throughs will be more beneficial; in other cases, a C-corporation will be preferable.
Corporate Benefits For federal income tax purposes, the corporation is regarded as a person and computes income in much the same way that individual taxpayers do. The reduction in the corporate tax rate to 21% provides numerous incentives for taxpayers to operate as a corporation. Switching from a pass-through entity to a C-corporation is simple, pass-through business owners merely check a box on Form 8832, making an election to be a
The first thing to consider before switching to a C-corporation is to determine whether you need the income from your C-corporation’s operations today. C-corporations have long been over shadowed by pass- throughs due to the dreaded double tax. Lowering the corporation’s tax rate encourages taxpayers to potentially defer paying the second level tax entirely.
Many tax minimization strategies involving C-corporations attempt to retain earnings in the entity opposed to distributing the income in the form of salaries or dividends. Since corporate earnings are taxed at only 21%, individuals are motivated to allow earnings to grow in the corporate structure. This can be accomplished in a few ways.
Passive Income First, the taxpayer may hold investment assets in a corporation. Say a taxpayer wished to create a fixed income portfolio. Fixed income is taxed at ordinary rates. The taxpayer would be better off purchasing the bond in a C-corporation where the ordinary rate is 21%. A similar strategy will result from dividend income.
Individual taxpayers pay up to 23.8% on dividend income. Corporation’s on the other hand pay the lower 21% tax rate and benefit from a 50% dividend’s received deduction, resulting in a 10.5% tax liability on dividends. IRC § 243. Depending on when the income is needed, the taxpayer will determine whether this strategy is a successful tax minimization technique.
Taxpayers utilizing this strategy will need to scrutinize their income and shareholder make-up to ensure a personal holding company tax is not triggered. A Personal Holding Company (‘PHC’) is a corporation where at least 60% of the adjusted ordinary gross income consists of passive income AND at least 50% of the outstanding stock is owned, directly or indirectly, by not more than five individuals. IRC § 542. To prevent high bracket individual taxpayers from utilizing a corporation to shield their income, Congress enacted a 20% penalty on undistributed income of PHCs that serve as vehicles to shelter passive income. PHCs are not subject to the accumulated earnings tax. IRC § 532(b). This tax may be avoided with careful tax planning.
Distribution Minimization Before 2018, individuals generally elected to receive all their corporation’s income in the form of wages because the top tax rate on wages was well below the combined rate on corporate profits. Today, Taxpayers are incentivized to reduce their salary draws and opt to maintain earnings in C-corporations. For instance, assume that a taxpayer makes $100k in salary compensation, this income would be taxed at ordinary rates resulting in a tax liability of 37,000 and an after-tax paycheck of $63,000. If the taxpayer’s $100k were maintained in the C-corporation, the income would be taxed at $21k, leaving $79k for the C-corporation to invest.
Though, this technique could flag the accumulated earnings tax. If a C corporation chooses not to distributes earnings to shareholders above an amount which the IRS deems to be beyond the reasonable needs of the business, the corporation may be assessed a tax penalty equal to 20% of the accumulated taxable income. IRC § 531. C corporations may accumulate earnings up to $250k without incurring an accumulated earnings tax. IRC § 535(c)(2). In the case of a personal service corporation, earnings may accumulate up to $150k without having to incur an accumulated earnings tax. Further, even if the exemption amount is exceeded, if the earnings are being accumulated for what the IRS considers to be the reasonable needs of the business, then the accumulated earnings tax won’t be imposed. IRC §535(c)*
Deferring the Second Layer of Tax
There are three common methods of avoiding the second layer of tax entirely. If the strategy is executed properly, the taxpayer will only pay corporate income tax at 21% and will delay paying individual tax on the income entirely.
One strategy is to wait to receive distributions from the corporation until a year the taxpayer makes less ordinary income, such as during retirement.
Tax deferral indefinitely can be achieved if the taxpayer holds her interest in the corporation until death. The 2018 tax bill raised the estate and gift tax exemption to $11.18M per individual, up from $5.49 million in 2017. This allows individuals to leave up to the exemption amount without their estates forced to pay 40% to Uncle Sam. IRC § 2001(c). Additionally, taxpayers’ heirs receive property acquired from decedents at the fair market value at the date of the decedent’s death. IRC § 1014(a).*
The taxpayer may also be able to achieve infinite deferral from the second layer of tax by holding her shares in the corporation through a Roth Individual Retirement Account. Opposed to traditional Investment Retirement Accounts (‘IRA’), Roth IRAs do not allow taxpayers to deduct contributions made into the account. IRC § 408A(c). Instead, taxpayers withdraw tax free distributions from their Roth IRAs after the age of 59 1⁄2. IRC §408(d)(1). This allows investments to essential grow tax free within the Roth IRA. The contribution limit to the Roth IRA remains at $5,500 in 2018. IRC § 219(a)(5). For service based corporations the limit may not be an issue. For capital intensive businesses, if the taxpayer has not already begun contributing to the Roth IRA, this strategy may be limited.
Another advantage of the corporate form are deductions. Pass through entities are restricted to deductions allowed as individuals. Comparatively, C-corporations allow the taxpayer the ability to deduct many expenses pass-through business owners are currently unable or limited to deduct, such as health insurance premiums, fringe benefits, and state and local taxes, charitable contributions, and property taxes. IRC §162, Treas. Reg. 1.162-1(a). In high income tax states such as California, Oregon, Minnesota, Iowa, and New York the impact could be significant.
Pass-throughs don’t pay taxes as a separate entity. Instead they pass their income onto their owners or shareholders, who pay taxes at the ordinary rate on their individual returns. In 2014, 95% of America’s 26 million businesses were organized as pass-through entities.* Pass-through entities include Sole Proprietorships, Partnerships, LLCs, and S-corporations.
To keep pass-throughs competitive with C-corporations, Congress has granted a 20% deduction for certain qualified business income, which in effect reduces the top tax rate from 37% to 29.6% (37%*(1-20% deduction) = 29.6%). IRC § 199A. This deduction is available to all taxpayers up to a threshold of $157,500 to single taxpayers or $315,000 to married filing jointly taxpayers. IRC § 199A(b)(3)(A). For filers above that threshold, the deduction is subject to limits and exceptions. Taxpayers in specified services businesses whose income exceeds the threshold amount are not eligible for the deduction. For all other businesses above the threshold amount a limit applies equal to the greater of (a) 50% of wage income, or (b) 25% wage income + 2.5% of the cost of tangible depreciable property, with the benefit phasing out between $315,000 and $415,000. IRC §199A(b)(2)(B)(ii). The inclusion of the 2.5% of the unadjusted basis of qualified property in the formula accommodates businesses which rely on the acquisition of capital, such as real estate.
Qualified Business Income (‘QBI’) is ordinary income less ordinary deductions. IRC § 199A(c). However, QBI does not include any wages a taxpayer earns as an employee. Further, as stated previously, many service trades or businesses over the exclusionary amount are prevented from receiving the deduction. Excluded trades or businesses are any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation of skill of 1 or more of the company’s employees. § 1202(e)(3)(A).
IRC § 199A is brand new and lacks guidance. For this reason, taxpayers will be eager to benefit from the equivocal language of the statute before the Treasury Department provides further interpretation. Some likely taxpayer activities are as follows.
The Rise of the Independent Contractor Since the pass-through deduction is denied to anyone who is an employee, taxpayers are incentivized to become independent contractors. Individuals who provide “specified services” (such as consultants, lawyers, and doctors) must have taxable income of less than the threshold amounts to be fully eligible for the deduction.
Before employee’s rush to put up their own shingle, they should consider the benefits they will be forgoing. First, employees will need to give up all their employee benefits, such as health insurance and 401k participation. Further, as an independent contractor, you’re on the hook for paying the full 15.3% of social security and Medicaid tax up to the social security wage base ($128,400), then the full 2.9% on income above that threshold.
Taxpayers must also be wary of potential penalties for misclassifying an employee as an independent contractor. Penalties can include back taxes or premiums, civil fines, interest, and other retroactive damage. The IRS has issued a 20-factor test for assisting taxpayers in determining which category they fall under.
Taxpayers in service trades or businesses above the threshold limit will be able to take advantage of the 20% deduction by creating separate entities for different revenue streams or through combining revenue streams to change the essence of their business.
To separate revenue streams from the service partnership, disqualified professionals will set up separate companies for ancillary benefits that are not considered disqualified. Service professionals may form real estate investment trusts (‘REIT’), which in turn will charge the service firm the maximum rent allowable to qualify some of the service income for the pass-through rate. Similarly, firms may create entities to handle their accounting, administration, janitorial services, etc.
Taxpayer beware, a Personal Service Corporation (‘PSC’) is a corporation for which the main activity is the performance of personal services, typically by employee-owners. If the PSC is formed for avoidance or evasion of Federal income tax, the Secretary may reallocate income to prevent questionable tax mitigation activities. IRC § 269A(a)(2).
The second strategy is to combine other qualifying businesses into the service partnership, to convert the combined entity into one that is not primarily providing services. This is best served when taxpayers already provide a blended business, such as installation and sales, or legal services and property management. In doing so the taxpayer will argue that providing services is ancillary to the main revenue income, one that is a qualifying activity under IRC § 199A.
Further caution, in the case of two or more organizations owned or controlled by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distributions, apportionment, or allocation is necessary to prevent evasion of taxes or clearly reflect the income of any such organization. IRC § 482.
Another option for service professionals is to join a firm not in the business of providing restricted services. Taxpayers can work in-house as a partner in a partnership engaged in another line of business and get the full deduction. For example, a lawyer becoming a partner at a real estate firm, architecture firm, or engineering firm.
There is not a cookie cutter approach to selecting an entity. The tax avoidance methods suggested in this article have not reinvented the wheel. These strategies have been proposed and utilized many times when the corporate tax rate has dipped significantly below individual rates.
Taxpayers must be cognizant of the “substance over form doctrine”, which maintains that the substance of a transaction is what governs the tax consequences of the transaction. The IRS has the authority to recharacterize transactions that are created for the sole purpose of tax avoidance and disallow any associated tax benefit. Some IRS tools at their discretion include IRC § 482 allocation of income and deductions among taxpayers, IRC § 542 personal holding company tax, IRC § 269A personal service corporation reallocation, and IRC § 535 accumulated earnings tax.
Taxpayers should use this article as a starting point to their analysis in determining which entity to choose and should conclude their analysis with the advice of knowledgeable tax practitioners evaluating the taxpayer’s specific needs.