Would Change of Business Structure be Beneficial Under New Tax Law?

The Tax Cuts and Job Act's decrease in federal corporate income tax rates from 35% to 21% should encourage all businesses operated in flow-through entities to consider whether converting to a C corporation would result in an overall reduction in income taxes. Obviously, an important part of this evaluation is the extent to which a businesses' owners could avail themselves of the deduction of up to 20% of the net income of that business provided by the new Section 199A - Qualified Business Income (QBI) - of the new law.

No two businesses are the same; and each analysis of whether to consider moving to a C corporation structure will be different as it will be based on specific facts and circumstances, including the tax brackets of the owners, cash flow needs, etc. However, in prioritizing the types of flow-through entities for which a C corporation structure may be beneficial, the following should be considered:

  • Is the business a "specified service trade or business"? If it is, the earnings derived therefrom could be subject to the much higher individual tax rate, as the owners may not be able to avail themselves of the Section 199A deduction. A "specified service trade or business" includes those involved in the professions (other than engineering or architecture). But they also include "consulting" businesses as well as those where the principal asset is the reputation or skill of one or more employees and/or owners. As a result, it may not be entirely clear whether the business involved the rendering of specified services. In this situation, our experience and judgement may be valuable in helping the business evaluate this.
  • Will the benefit of the Section 199A deduction of QBI be substantially curtailed by the wage and property limitations? The new deduction can be limited by the amount of wages paid and fixed assets deployed. If so, the effective tax rate on such income could be much closer to the individual tax rates, making the corporate tax rate much more attractive.
  • Are a substantial portion of the earnings reinvested in the business? Even if the business qualified for the Section 199A deduction, taking advantage of the low corporate tax rate and deferring the individual tax by not taking dividend distributions could be beneficial, depending on the period of reinvestment.
  • Does the business have significant sales to non-U.S. customers? A benefit contained in the Tax Cuts and Jobs Act, which has not received a lot of attention as yet, is the deduction for "foreign derived intangible income" (FDII). A bit of a misnomer, the deduction is 37.5% of income associated with eligible foreign sales in excess of a specified 10% return on average tax basis of tangible property subject to Section 167 depreciation. Eligible foreign sales include the sale of property (goods) to customers outside the U.S. for use outside the U.S., and the provision of services to any customer, or with respect to any property, located outside the U.S. It should be noted that this deduction is available only to C corporations. The effect of taking the FDII deduction could be the reduction of the effective U.S. corporate tax rate on eligible income to as low as 13.125%

The corporate tax rate reduction and the Section 199A deduction for eligible flow-through businesses are two of the most significant provisions of the Tax Cuts and Jobs Act. Their respective potential benefits deserve careful analysis and consideration by experienced tax CPAs in order for the owners of flow-through entities to make the most advantageous decisions for their businesses.

 


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