By Robert Duquette, CPA
More than a year has passed since the passage of the Tax Cuts and Jobs Act lowered tax rates for individuals and C corporations. Additionally, with final Treasury guidance released in January 2019 related to new Section 199A’s 20 percent pass-through deduction, business owners and their tax advisers now have a substantial body of information to evaluate if their business clients are doing business in the optimal tax form for their circumstances. This article shares what I believe are the new effective combined federal and state income tax rates for C corporations vs. pass-through entities solely doing business in Pennsylvania, the underlying assumptions I made behind those rates, and other tax considerations before deciding or recommending an entity choice for a new business or converting from one form to another.
Combined Federal and State Effective Tax Rate
Results of searches on the web related to this topic usually do not consider Pennsylvania’s high U.S. C corporation income tax rate (second-highest in the Unites States) vs. Pennsylvania’s relatively low personal tax rate. Weighing both can significantly affect your recommendation, as would other variables identified below.
As a starting point for this discussion, I created Exhibit A (below). It is a simplistic post-tax-reform comparison of the combined federal and Pennsylvania effective tax rates of operating as a C corporation vs. a pass-through, assuming the business is 100 percent in Pennsylvania and its owners are all “active” (materially participating in the business). I also considered in the exhibit other key variables, such as do the owners need dividends or plan to sell the business soon, and would the full 20 percent Section 199A pass-through deduction be available.
As you see in the Notes to Exhibit A, I made several assumptions for simplicity and to be able to keep the data readable in one exhibit. However, any one of these assumptions can be changed and easily integrated into your own customized version of Exhibit A to generate a more accurate comparison that fits your circumstances. For example, if you operate in more than one state, or have owners in more than one state, then replace the Pennsylvania rates I use with a blended state rate more reflective of your own apportionments. Then look at Exhibit B (below). It identifies and lists several other tax considerations, some of which could be added into your basic model. Again, any one of these other considerations, or other issues you identify more unique to your circumstances, may cause you to reconsider your recommended choice of entity.
Summary of Exhibit A
If regarded as a C corporation for tax purposes, and operating solely in Pennsylvania and owned 100 percent by a Pennsylvania resident, then the combined federal and state effective tax rate could be as low as 29 percent (if the earnings are never distributed and the company never sold), or as high as 48 percent (if the earnings are routinely distributed or the company eventually sold). If regarded as a pass-through entity for tax purposes (e.g., an S corporation, LLC, GP, or sole proprietorship), operating solely in Pennsylvania, and owned 100 percent by a Pennsylvania resident, and the owner is actively managing the business, then the combined federal and state effective tax rate could be as low as about 33 percent (if the business earnings are eligible for the new 20 percent pass-through deduction), or as high as 40 percent if the business doesn't qualify for the new pass-through deduction.
Therefore, a C corporation may make more sense for tax purposes (subject to the other considerations listed in Exhibit B) if you do not need the earnings to live on and don't plan on selling the business, because the combined effective tax rate could be as low as 29 percent. The best pass-through effective tax rate would be 33 percent even if you can get the full 20 percent special deduction.
If you need the entity earnings in cash to live on or expect to sell the company someday, the C corporation combined effective tax rate becomes 48 percent (ignoring the present value of when those taxes are paid). The pass-through form would therefore make more sense for tax purposes (again, subject to the other considerations listed in Exhibit B), whether or not you and the business qualify for the 20 percent pass-through deduction because the pass-through combined effective rate would be as low as 33 percent with the special deduction or 40 percent without the special deduction.
Exhibit B: Other Tax Considerations Regarding Choice of Entity
Here is an extensive, though not exhaustive, listing of other considerations when weighing choice of entity. (You may have additional tax issues or variables applicable to your circumstances which should also be considered.)
- Applicability of the Section 199A 20 percent pass-through deduction and any planning that could be done to take advantage of it. (This effectively reduces the federal rate by up to 20 percent of the taxpayer’s marginal tax rate.)
- The impact of self-employment taxes. This can be very complex when considering the 15.3 percent FICA rate, the cap on that rate, the 2.9 percent additional Medicare SE rate, the 0.9 percent Medicare surtax, and the 50 percent deduction for self employment taxes. The extent to which these taxes apply depends on the form of entity, the owner’s level of involvement in the business, whether the owner has other sources of earned income that was already subject to payroll taxes, and whether they would have applied if held in C corporation form.
- Level of distributions vs. earnings retained. Any level other than zero and 100 percent would change the Exhibit A conclusions to a result in between that shown.
- Could the accumulated earnings tax apply to an unreasonable buildup of cash if dividends are not done?
- Does the owner intend the business to be passed on to the next generation? Current estate tax rules allow for a tax-free step up of the stock to fair value, thus avoiding the double tax on earnings retained in a C corporation.
- Will the business be sold in the near future, or in the long term? The present value of the expected taxes should be modeled out vs. assuming the double taxes of a C corporation structure are paid currently as assumed in Exhibit A.
- Business value. This impacts how much of the gain on a future sale is really from earnings retained (thus subjected to “double tax”) vs. new appreciation above those earnings (which would not be subjected to double tax if C corporation stock is sold vs. the assets).
- In a future sale of the company, would it be stock or assets, and what outside and inside tax basis, respectively, do they have for purposes of estimating the gain or loss on the sale?
- How much of the potential gain on a future sale would be taxed at ordinary rates vs. preferential rates?
- Is the owner passive or active for purposes of the applicability of the 3.8 percent net investment income tax on the business earnings?
- Other entity level income potentially subject to the net investment income tax. Consider taxpayer’s modified taxable income thresholds for such tax.
- Export sales or income from licensing to foreign unrelated or related parties. Generally, there is effectively (after a very complex calculation) a reduced tax rate to as low as 13.125 percent on the profit of such income, but only C corporations can take advantage of it.
- IRC Section 1202: This provision, if applicable, would permanently exempt part or all of the gain on a future sale of the business if held in C corporation form and it is “qualified small business stock.”
- Section 1045 deferral of a gain on sale. This is applicable only to C corporation owners owning “qualified small business stock.”
- Does the business itself have potentially preferentially taxed income, such as dividends and capital gains?
- What if tax laws change again after converting to a different form? (Taxpayers will usually have to wait five years to be able to convert back.) Note that the individual provisions of last year’s tax reform, including the lower rates and the 20 percent pass-through deduction, will expire at the end of 2025.
- Does the business’s capital structure allow a change to the desired form? (e.g., S corporation “one class of stock” requirement, along with the ownership restrictions.)
- If an existing business converts from a C corporation to an S corporation, will there be a LIFO recapture tax, a passive investment income tax, or a built in gains tax at conversion and for a few years post conversion?
- If an existing business converts from S status to C status, would the AAA account be lost? If Q Subs are involved, will they be converted?
- If an existing business converts from a partnership or LLC to a corporation, could there be partnership tax issues on the transfer of the assets and liabilities to the new corporation?
- If an existing business converts from C or S corporation status to partnership or LLC status, will there be tax on the deemed appreciation of the corporation upon its liquidation and subsequent partnership formation?
- Would accounting methods and periods survive the conversion or must they be changed?
- Would a conversion trigger a split in the accounting year for tax return purposes?
- Estate planning considerations?
- Effective state tax if business is done in states outside Pennsylvania?
- International tax considerations if there are foreign affiliates?
As you can see, operating in Pennsylvania can significantly affect the after-tax cash of your choice of entity compared with solely focusing on the federal aspects. But even the federal impact must be carefully evaluated if the entity will retain its earnings or could be sold in the near term. And as illustrated in Exhibit B, there are dozens of other issues that should be considered and brought to your client’s attention.
In summary, the recommendation as to choice of entity must be carefully analyzed, documented, and customized to fit all relevant client circumstances. For many clients, this will be straightforward; others may need to construct a more complex model that considers present value, self-employment taxes, level of exports, multistate presence, and any other item listed in Exhibit B. Having the process done right and documented properly – including consulting with legal counsel about all the legal implications of the entity choice – will hopefully result in a more optimal tax situation … at least until the tax laws change again!
The information contained in this article is general in nature and is not intended, and should not be construed, as legal, accounting or tax advice, or opinion provided by the author to the reader to be relied upon in connection with a specific situation or client, or to recommend a final decision about the best choice of entity, nor is the information intended to be construed as written advice subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230. This material may not be applicable to, or suitable for, the reader's specific circumstances or needs, and may require consideration of nontax or other tax factors if any action is to be contemplated. The reader should contact his or her tax and legal professionals before taking any action based upon this information. The author assumes no obligation to inform the reader of any changes in tax authorities or other factors that could affect the information contained herein.
Robert Duquette, CPA, is a retired EY tax partner who is currently a professor of practice in the College of Business at Lehigh University and a member of the Griffin/Stevens & Lee Tax and Consulting Network. He has served on PICPA’s Federal Tax Committee for over 25 years, focusing on federal tax reform and the national debt.