The new tax bill passed by Republicans last week has opened up a whole new set of tax questions. For business owners, one of the main questions surrounds the new corporate tax rate. At 21%, it is set lower than the pass-through rate for businesses, which is capped at 25%. That has some asking the obvious question: Should I change my company’s status from a pass-through corporation to a corporate structure?
Unfortunately, the answer is, it depends. And it will probably require some sound tax advice. But let’s start with what exactly is a pass-through corporation? A pass-through corporation is a legal entity and refers to how a business pays taxes. According to the Cornel Law School, pass-through corporations are sole proprietorships, partnerships and S-Corporations. A C-Corporation, or Inc., is the more traditional company setup.
Pass-through companies represent about 95% of all businesses in the U.S., and size does not matter. An owner-operator could be set up as a pass-through corporation and large corporations, such as the Trump empire, can be designed as a pass-through.
For tax purposes, a pass-through company would pay taxes on income through its shareholders, i.e., the owners. That income is taxed at the individual’s income tax rate. According to the New York Times, 40 million taxpayers claimed pass-through income in 2014.
For years, businesses set up as pass-through corporations have been able to pay lower taxes, in general, than corporate taxes, which had a 35% rate. For small businesses, such as owner-operators and small trucking fleets, this was a significant tax savings.
Comparison of corporation status
With the new tax law dropping the corporate rate to 21% and setting the pass-through at 25% (with the first 20% deductible), many small businesses may be wondering if changing their tax structure is a better option.
First, understanding what a C-Corporation and how it differs from an S-Corporation, or pass-through, is helpful. C-Corporations feature limited liability for directors, officers, shareholders and employees. They also will continue even if the owner leaves the company. There is also no limits on the sale of stock or shareholders, and there are special tax-deductible business expenses.
S-Corporations, on the other hand, enjoy some of the same benefits, but they are limited to 100 shareholders and they cannot be owned by another C-Corp, S-Corp, LLC, partnership or many trusts, explains incorporate.com.
A disadvantage to a C-Corp is double taxation. The company must pay taxes on its income, but any money distributed to shareholders is also taxed. C-Corporations are also more heavily regulated.
With that basic knowledge, you can now go about making an informed decision on whether you should switch your business to a C-Corporation.
“For tax years after 2017 and before 2026, individuals would be allowed to deduct 20% of “qualified business income” from a partnership, S Corporation, or sole proprietorships, as well as 20% of qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income,” according to Alistair M. Nevius, editor-in-chief with the Journal of Accountancy.
There are a few other issues, such as the 20% deduction being phased out based on W-2 wages above a certain threshold of taxable income, beginning at $315,000 for married couples and $157,500 for single filers.
According to the Tax Policy Center, nearly 90% of pass-through businesses already pay a tax rate of less than 25%, the cap in the new bill. Only those individuals with tax rates above the new 24% rate ($157,500 for single filers and $315,000 for married filing jointly) would pay the 25% rate.
So the question then becomes, if you are currently set up as a pass-through entity, should you convert your business to a C-Corporation? In the end, it comes down to each unique situation. Some businesses may find it advantageous while others may not.
Experts warn that the cost of being a C-Corporation can be expensive, and getting that 21% corporate tax rate may not pay for those expenses. The best advice is to consult with your tax advisor or attorney who can weigh the benefits of either setup.
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