With the Tax Cuts and Jobs Act (TCJA) going into effect, many construction business owners are re-evaluating their choice of entity. The TCJA has cut the federal “C” corporate income tax rate to a flat rate of 21% from a top rate of 35% and removed the corporate alternative minimum tax (AMT). Owners of pass-through entities — partnerships, S corporations and LLCs — are taxed on their shares of business income at rates as high as 37% (down from 39.6%).
A C corporation offers substantial tax advantages for businesses. Pass-through entities offer advantages as well. Here are some factors to consider when determining whether to restructure your business as a C corporation.
Are You a C Corporation?
Determining whether your business could benefit by identifying as a C corporation is a complex process that depends on a range of tax and nontax factors. Under federal tax income laws, a C corporation is a business taxed separately from its owners. Your company may benefit from being taxed as a C corporation if:
- You don’t plan to distribute earnings.
- Retaining earnings doesn’t raise Accumulated Earnings Tax (AET) or Personal Holding Company (PHC) tax concerns.
- Your owners are ineligible for the passthrough deduction.
- You don’t intend to sell the business or your ownership interests in the coming years.
- You don’t expect the TCJA to be repealed or substantially modified in the foreseeable future.
Determining Your Pass-Through Rate
While the top individual income tax rate is 37%, a pass-through owner’s true tax rate may be higher or lower. For example, an owner who doesn’t materially participate in the business may be subject to an additional 3.8% net investment income tax (NIIT).
Additionally, TCJA created a pass-through deduction, allowing owners of certain pass-through entities to deduct up to 20% of their share of qualified business income (QBI) through 2025. Depending on a variety of factors, the deduction may be subject to limitations and exclusions. But assuming that a pass-through owner qualifies for the full deduction and that all of their income from the construction business is QBI, the owner’s actual pass-through rate will be approximately 29.6%.
Avoiding Double Taxation
Even with the benefit of the pass-through deduction, a pass-through entity’s effective tax rate is higher than the 21% corporate tax rate. If a C corporation distributes its earnings to its owners in the form of dividends, that income gets taxed twice — once at the corporate level at the 21% rate, and again at the individual shareholder level at rates as high as 23.8% (the 20% qualified dividend rate for high-income taxpayers plus the 3.8% NIIT). Double taxation results in an effective tax rate in excess of the top 37% bracket for individuals.
Some C corporations can avoid this by paying out earnings to owners in the form of salaries and benefits or by reinvesting earnings in the business. In contrast, the tax on salaries can be as high as the top individual rate of 37%. Note, however, that the AET and the tax on personal holding companies (PHCs) may erase the benefits of retaining corporate earnings under certain circumstances.
Always Prepare an Exit Strategy
Even if a business can operate as a C corporation without distributing its earnings, doing so merely deflects, rather than avoids, double taxation. If the business is sold, sale proceeds will be taxed at the corporate level and again when distributed to the shareholders. Also, the owner’s basis will not be increased for profits that remained in the company as it is with a pass-through entity, further increasing the tax at that time. Owners should consider a pass-through entity for a sale of business/ ownership interests in the near future.
What if TCJA is repealed or modified?
Although the 21% corporate tax rate is called a “permanent” change, that just means that the rate isn’t scheduled to expire or “sunset” in 2026, like many of TCJA’s individual income tax provisions. That doesn’t mean Congress won’t repeal or modify some or all of the TCJA’s corporate provisions down the road.
Consider the possibility that the corporate tax rate may be increased in the future. If you organize your business as a C corporation or convert an existing pass-through entity into a C corporation and the advantages of C corporation status are eliminated, converting back may prove to be cost-prohibitive.