Many business owners are inquiring whether they should convert their business from a pass-through entity (sole proprietorships, partnerships, S corporations and LLCs) to a C corporation now that the corporate tax rate has dropped from 35% to 21%. Alternatively, many business owners who were contemplating converting from a C corporation to a pass-through entity are wondering if it is still a good idea.
One of Quist’s clients who specializes in software development and is structured as a C corporation is struggling with this conundrum. A considerable amount of research about the benefits of converting to an S corporation had already been done, but now that the corporate tax rate dropped so dramatically the company is wondering if it economically still makes sense?
We focused our discussion with the client around three main questions:
Service vs. Non-Service Business
The confusion about entity choice is primarily due to the creation of a 20% deduction for “Qualified Business Income” (QBI) as part of the Tax Cut and Jobs Act. The effective tax rate on income earned on qualified pass-through business owners can be as low as 29.6% (37% x (1-20%) = 29.6%) when combined with the decrease in the top ordinary income tax rate for individuals to 37%. However, only certain pass-through business entities qualify. The definition of a “qualified trade or business” is somewhat elusive as it is defined as any business not in a “specified service”; namely, health, law, accounting, actuarial service, performing arts, consulting, athletics, financial and broker services. Additionally, any trade or business in which the principal asset is the reputation or skill of one or more of its employees would be considered a “specified service”.
QBI eligibility is not clear for our client who sells both products and services. Because of the proportion of revenues derived from services versus products, it was ultimately decided that they would not qualify for QBI; however, there is scant guidance at this point with the IRS as to what specific criteria they will use to determine eligibility.
Profit Distribution vs. Profit Retention
C corporation income is taxed at the entity level at a 21% tax rate and then the net income is taxed again at 20% when shareholders receive dividends. As such, the greater the distributions to shareholders, the more likely a pass-through entity structure may make sense. However, if a business does not intend to distribute profits, but instead plans to reinvest capital in the business, then a C corporation may make more sense.
Our client is fast growing and considered to be in an expansion phase. Outside of distributions made to shareholders to cover tax liabilities, all remaining profits would be retained in the business to fuel growth. On the surface, this would point toward remaining a C corporation.
Continue to run the Company vs. Planning for a Sale
Selling your business as a C corporation has the same double taxation implications as making distributions to shareholders. A business owner that is considering selling their business in the near to intermediate term would be better off as a pass-through entity. However, keep in mind that while there is generally no tax upon conversion from a C corporation to an S Corporation, if assets are disposed of within 5 years of conversion, there is a tax on built-in gains on appreciated assets that the C Corporation had upon conversion.
Conclusions: The business owner we worked with knew that within 5-7 years they were moving toward an internal or external ownership transition. In our discussions this became the driving factor. Ultimately, our client chose to convert to an S Corporation. For most business owners, it is vital to work closely with a professional advisor to understand all impacts of choosing your entity.
Have questions abouthow the new tax laws affect the value of your business? Quist Valuation can help. Let’s set a time for a free 30-minute consultation. We can discuss the specifics of your business and identify the next steps needed to assess the value of your company.
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