Can You Get Rich From the New Tax Law by Becoming a Company?

Can You Get Rich From the New Tax Law by Becoming a Company?

Income tax rates were slashed on conventional corporations (so-called C corporations), but the great majority of corporations, especially smaller ones, are in another category. They are pass-through entities, meaning their tax liability is borne by the owners on their personal tax returns. Rates were cut for pass-throughs, too, but not nearly as much, and provisions in the law, passed in late December, limit tax breaks for pass-through vehicles of certain types and sizes.

The discrepancy in headline tax rates has persuaded some owners of pass-through entities — which include partnerships, Subchapter S corporations and limited-liability companies — to consider converting to C corporations (often called C corps). In certain cases that may be the right move, tax advisers say. They encourage owners to calculate their tax liability under different structures to assess which would work best.

Still, when all tax consequences are factored in, they expect most people to be better off keeping what they’ve got.

“People will have to decide, ‘Should I operate as a pass-through or as a C corp?’” said James Markham, a tax specialist at Ernst & Young who focuses on issues that entrepreneurs face. To determine the better way to go, “you have to run the numbers.”

The basic arithmetic gives the edge to C corps, for which the top tax rate has been cut to 21 percent from 35 percent. The top rate for individuals has been cut to 37 percent from 39.6 percent, and most qualified business income — essentially net profits — for pass-through entities gets a 20 percent deduction. That brings the top rate from 39.6 percent to 29.6 percent (a 20 percent deduction applied to the new 37 percent rate), well above the top C corp rate.

But we’re talking about the tax code: It’s not that simple.

Advisers point out that C corp income paid out as dividends is taxable to the recipients, usually at 20 percent, from profits that have been taxed already. That double taxation more than nullifies the advantage of the lower income tax rate.

Say a company earns $100 and pays $21 in tax; if it pays the remaining $79 out as a dividend, the recipient is likely to end up with an additional 20 percent tax bill, leaving a net payment of only $63.20.


Details remain to be pondered about the tax law and its effect on Electro Scan, but Mr. Hansen says is leaning toward making the change.

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“In most cases, the double taxation for C corps versus single for flow-throughs makes a lot of difference,” said Ian Shane, a partner at the law firm Michelman & Robinson. “If you’re going to put money into a corporation and keep it there and reinvest from it, you’re probably better off in a C corp, but very few people are going to do that.”

Chuck Hansen, founder and chief executive of Electro Scan, a Sacramento, Calif., company that uses high tech methods to seek out flaws in sewage systems, may be one of those people. Mr. Hansen is contemplating converting Electro Scan into a C corp from an S corporation.

“If I’m accumulating cash and won’t have to pull it out, and I can make investments on the company platform, why not?” he said. While a lot of details remain to be ponder concerning the tax law and its effect on Electro Scan and his other business interests, he said, “I’m already leaning toward that.”

Another reason to convert to a C corp is that the deduction for pass-throughs is limited if the income is earned providing services that depend on the owners’ reputation and skill. In that case, it can be applied only to qualified business income of $315,000 for married owners and half that for single owners, with a portion of the deduction available on the next $100,000 (for married owners) or $50,000 (for single owners) of income. Electro Scan provides “technology as a service,” Mr. Hansen said, so it may run afoul of that provision.

“It’s a coin flip on whether I’m happy or mad about this thing,” Mr. Hansen said of the law.

The treatment of service businesses under the new law is still unclear. For example, the deduction limit on services applies explicitly to activities like health, law, accounting, insurance, performing arts, consulting, athletics and financial services. While architecture and engineering should be eligible for the full deduction, professionals may still “get caught by the ‘reputation or skill’ provision,” Mr. Shane said. “Follow the logic here? No, neither do I.”

Other provisions of the tax bill in general are clear enough but still hard to factor into tax planning. Making the most of a new rule on writing off depreciable property, for instance, might require an ability to travel back in time.

Andrew Oswalt, an analyst at TaxAct, a provider of tax filing software, noted that businesses can immediately write off the full value of equipment placed in service beginning Sept. 27, nearly three months before the bill was enacted.

If you’re unlucky enough to have put a big piece of machinery into service on Sept. 26, it would feel unfair, he said. “It hurts a bit.” In that case, the previous regulations hold: You are entitled to write off only 50 percent of the value.

Another aspect of the law could inflict pain: the rules regarding how much pass-through owners decide to pay themselves. They are required to take a salary that reasonably reflects the work they do as employees but usually will take as little as possible so they can minimize payroll taxes. That incentive grows under the new law because salary does not receive the 20 percent qualified income deduction.

To try to curb that tendency, Mr. Oswalt said, the rules generally require that the deduction be capped at 50 percent of a firm’s W-2 wages; very small salaries will result in smaller deductions. But this provision applies only to businesses with income above the $315,000/$157,500 threshold, he said.

While the new law adds some complications, Mr. Markham at Ernst & Young said it makes life simpler for some not-very-small businesses. Ones with gross receipts below $25 million can use the simpler cash method of accounting rather than the accrual method; the previous ceiling was $5 million.

Provisions such as this and the ability to write off equipment expenses fully are “huge in terms of complexity for small businesses,” Mr. Markham said.

The law gives business owners a lot to ponder, but Mr. Oswalt encourages them not to get carried away.

“Don’t overthink it,” he said. “There’s not a ton of things that need to be done.” If you run a pass-through entity, he said, “just educate yourself and think about how it’s going to affect your 1040.”

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