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Tax Reform and Passthrough Entities: Moving Beyond Basic Math

The 2017 Tax Act posed a pivotal dilemma to private business owners about the way their businesses are structured for tax purposes. While the Act offered a combination of tax-rate reductions and various tax breaks for C corporations and certain owners of certain passthrough entities, lack of clarity in the new law leaves many passthrough owners struggling to understand whether they will qualify for such tax-rate reductions and whether it makes sense to retain passthrough status.

Wolfe Tone
Wolfe Tone

When the Act was passed last December, it lowered the C corporation federal tax rate to 21 percent, and introduced advantages to certain individual and trust owners of passthrough entities through a special 20-percent passthrough deduction. However, many business owners will not qualify for the full 20-percent deduction.

In addition, a new cap on state income tax deductions at the individual level ($10,000) may cause state income taxes generated from ownership in a passthrough entity to become 37 percent more expensive because of the limited or lost deductions. In concert, these changes left many passthrough entities wondering whether now is the time to convert to a C corporation given the reduced corporate income tax rate.

This might seem like a problem solved with basic math. Understanding the rate differential and the detrimental impact of limited state income tax deductions by individual shareholders may be easily quantifiable. However, the new $10,000 cap on deductions for state income, sales, and property taxes means that many individuals will no longer receive a federal benefit for state taxes paid as a result of their allocable share of passthrough income.

James Calzaretta
James Calzaretta

State taxes remain deductible by C corporations. Thus, the analysis would appear to be straightforward — claiming the C corporation saves at least 8.6 percent annually, plus any amounts saved by having deductible state income taxes.

Determining whether a business qualifies for the 20-percent passthrough deduction may not be a simple task, in large part due to uncertainties created by the new law. For example, the passthrough deduction is limited to income that is effectively connected to a U.S. trade or business. It also expressly excludes a number of businesses, including those in the fields of health, law, accounting, investment management, and consulting.

Qualitative Considerations

The new law can serve as a catalyst for owners to engage in a series of fundamental conversations about the structure, strategy, and future of their business. Understanding how to proceed with considering a conversion from passthrough to a C corporation starts with knowing how the business is being taxed now, how its owners are being taxed at an individual level, understanding how the business accrues value, and projecting its ultimate exit strategy. And that means asking a series of foundational and qualitative questions, including but not limited to:

Fiona Chambers
Fiona Chambers

Do owners plan to retain earnings for future investment in the business? Many might find the choice of whether or not to convert to a C corporation or remain as a passthrough entity to be a fairly straightforward calculation. If 100 percent of the business income is retained, the annual federal effective tax rate on the C corporation drops all the way to 21 percent, while the passthrough entity’s rate is still 29.6 percent.* Thus, the initial calculation will favor C corporation status.

However, this analysis changes as one considers an individual owner’s desire for access to cash. A dollar earned and distributed by a passthrough entity that qualifies for the full passthrough deduction remains taxed at a top federal marginal rate of 29.6 percent, while a dollar earned and distributed by a C corporation will be taxed at an effective rate of 36.8 percent (first at the corporate level at 21 percent and then again as a dividend at 20 percent). Thus, the desire for access to cash will have a dramatic impact on selecting between passthrough versus C corporation status.

What is the business’s growth trajectory? If the business is expected to grow meaningfully, the return on investment of retained earnings could be considerably greater than the value of distributions taken from the business, on an after-tax basis.

Travis Loomis
Travis Loomis

Consider that the historical average return of funds invested in the S&P is 10 percent. If the company is able to grow at a rate of 15 percent from the investment of its retained earnings into the operations of the business, its overall revenue could double in approximately two-thirds the time, compared to having been distributed to the owners and invested in the S&P at the 10 percent rate.

When it is sold, the value of the business would have risen far more than the total of after-tax cash received and invested by the owners had they taken earnings out of the business. But if the business owners are only focused on capturing the passthrough deduction, without factoring the value of reinvested earnings and their long-term goal of increasing the overall value of the business, they may not be able to see that a better option is available to them.

Is an exit from the business on the near-term horizon? A C corporation may not be the best approach if the owners plan to sell their businessin the foreseeable future. Consider that buyers often seek to receive a step-up in the tax basis of the business assets they’re acquiring. If assets are sold in a C corporation, the resulting gain is taxed at the corporate level and then again as the remaining proceeds are distributed to the selling shareholders. Conversely, a passthrough entity generally provides the flexibility for a buyer to purchase a business and step up the basis of the acquired assets without subjecting the seller to two layers of tax. This is also true if the seller is an S corporation that is not subject to the built-in gains tax.

How do state and international income taxes affect the analysis? Converting to a C corporation may impact how a business is taxed in various state jurisdictions as well as the taxability of its international operations. State taxes can have a significant impact on the analysis. The state corporate income tax rates can be significant (e.g., 12 percent in Iowa, 9.99 percent in Pennsylvania, 9.5 percent in Illinois, 11.5 percent (incl. surtax) in New Jersey, and 8.84 percent in California).

There are several states where the corporate tax rate is significantly higher than the individual tax rate, including Alaska, where there is a 9.4 percent difference, and Pennsylvania, which has a 6.92 percent difference. Even with a potential federal income tax deduction for the corporate state income taxes, the magnitude of state income taxes levied upon a corporation can affect the analysis. For example, consider a state with an individual state income tax rate of 5 percent and a corporate income tax rate of 8 percent. If all business activity is conducted in this state (i.e., no apportionment variables exist), the corporation would pay $8 for every $100 of profit. The federal income tax deduction is $1.68 (at 21 percent federal rate) for a net cost of $6.32 a significant increase over the $5 state income tax on the individual owner of a passthrough entity. This comparative analysis must also account for state by state differences that typically exist between the corporate and individual apportionment rules as well as differences in the computation of the tax base.

A related consideration is the fact that most states allow resident individuals to claim a credit for taxes paid to other states on income coming from a passthrough entity. As a result, the analysis needs to address the state tax rules in the states where the business is operating and the state tax rules in the states where the owners live.

Numerous other state tax variables can also affect this analysis. Several states impose net worth taxes on corporations, but not on partnerships or limited liability companies. Several states also impose income taxes on passthrough entities.

Moreover, the Act also had broad international tax implications. It moved the United States from a worldwide to a hybrid territorial tax system. Depending upon a company’s tax structure outside of the United States, these changes may impact the U.S. tax on non-U.S. operations, and owners may need to consider changes to the tax and legal structure of their international operations.

The technical capabilities of the existing internal tax department should also be considered, and whether it has the talent and technology to handle the new reporting requirements. If not, organizations should consider what changes should be made and how much this would cost the organization.

These are all questions that can ultimately be decided through a combination of thoughtful analysis. In isolation, the answers may argue for or against a conversion. That is because the most important consideration is how the overall tax situation looks when owners put all of these pieces together.

― Produced by Wolfe Tone, national tax leader, Deloitte Private; James Calzaretta, partner, Washington National Tax; Fiona Chambers, partner; and Travis Loomis, senior manager, all with Deloitte Tax LLP.

* This analysis is using federal income rates only. It does not include state tax rates nor taxes imposed for self-employment or net investment income.
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