Choice of Business Entity under New Tax Law

The Tax Cuts and Jobs Act (TCJA) reopens the discussion of whether a business should be conducted as a C corporation or pass-through entity (such as a partnership, S corporation, or sole proprietorship). This is primarily due to the new 21% corporate tax rate. (Under prior law, C corporations were subject to graduated tax rates, with a top rate of 35%.) Given this is substantially lower than the top individual tax rate of 37%, many business owners are considering switching to C corporation status.

In general, choosing the right business entity involves various factors, and there is no automatic right answer. Before converting a business to a C corporation, owners should consider the following:

  • The TCJA creates a new deduction for Qualified Business Income (QBI) from pass-through entities. The deduction can be up to 20% of QBI, but it’s only available for 2018–2025 unless Congress extends it. If business owners can benefit from meaningful QBI deductions, operating as a pass-through entity is probably the way to go.

  • C corporations are subject to double taxation, meaning that corporate income is taxed once at the entity level and again when it’s distributed to shareholders as dividends. Double taxation can be avoided if corporations retain all their profits to finance growth. However, they must watch out for the accumulated earnings tax (or personal holding company tax) if profits accumulate beyond the reasonable needs of the business.

  • It’s important to consider the tax consequences of a potential exit strategy. Generally, it’s risky to hold significant assets that are likely to appreciate (such as real estate and certain intangibles) in a C corporation. If the assets are eventually sold for substantial gains, it may be impossible to get the profits out of the corporation without double taxation.

  • Other new factors to consider are reduced tax rates on individuals for 2018–2025 and super-generous first-year depreciation allowances.

Other things being equal, C corporations are now more attractive thanks to the 21% rate, but pass-through entities will still be preferred in some cases. We would need to analyze your particular circumstances to determine if a C corporation is right for you.