Tax reform legislation has now been passed by both the House and the Senate, with ongoing conference committee activities aimed at coming up with a final package that both legislative bodies can agree upon. One of the areas of high importance to closely-held business owners involves the tax treatment of pass-through entities. The House recipe for tax reform relies upon a 25 percent tax rate, for which only a 30 percent component of pass-through entity income would generally qualify. The Senate’s approach relies upon a 23 percent deduction in arriving at the amount of pass-through income which will be taxed.
Depending on the type of business activity, each approach provides pros and cons. For service businesses, neither approach provides the same level of tax savings that would be available to non-service enterprises. And, neither is generally viewed as offering a simplification of current tax provisions. A common question we’re getting from many current pass-through business owners is whether they should continue with pass-through classification if a 20 percent tax rate can be realized by switching to a non-pass-through C-Corporation.
A full evaluation of the final details of any tax reform legislation enacted and signed into law by the President will be a critical component of decisions in this regard. Should the Senate’s approach to tax reform involving delaying the effective date of a 20 percent C-Corporation tax rate in 2019 rather than 2018 win out in conference activities, there will be ample time to review such matters. Should the House’s approach carry the day, the timeframe for making decisions will be materially condensed. Generally, an effective date of January 1st for a change over to C-Corporation treatment can be accomplished by filing the appropriate elections within 75 days from the beginning of a calendar year filer.
When analyzing the pros and cons of pass-through versus C-Corporation tax characterization, you generally start with the potential for short-term benefit versus the longer-term cost of C-Corporations. In many cases, a 20 percent current Federal tax rate would represent a material benefit. However, it would also be important to consider the potential complexities of owners incurring a second level of tax on corporate profits distributed as dividends, or higher ordinary tax rates if corporate profit is paid out as compensation. This is worth contemplating both for the short run as well as longer-term, particularly if a liquidation of ownership event is on the horizon.
Ownership interest held by individuals wherein material wage payments would not be supportable are not favorable to a change to a C-Corporation. The reasonableness of salary arrangements to any owner as well as related party rent, royalty, and other payments to owners will potentially have increased exposure as well.
Businesses with significant levels of appreciation in business assets, including goodwill, may present challenges in connection with potential exposure to “built-in gains” tax should you decide to convert back to pass-through characterization under a more favorable future tax environment.
A decision to convert to a C-Corporation may also lead to other tax planning considerations, including whether an existing business enterprise should be split apart into separate entities with some components continuing to maintain pass-through characterization. There may be current tax implications; however, longer-term tax consequences may be appealing.
There are no one-size-fits-all or easy answers when evaluating what may be appropriate for your business in a post-tax reform environment. We will welcome the opportunity to assist you.
We invite you to contact us to discuss your goals and concerns in this regard and learn more about the options that may be best for your business.
Michael R. Viens is a director with Kreischer Miller and a specialist for the Center for Private Company Excellence. Contact him at Email.
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