C-Corporation versus Pass-Through Entity: How the Tax Cuts and Jobs Act Defines the Entrepreneur’s Decision

The Tax Cuts and Jobs Act (TCJA), tax reform legislation enacted in 2017, has altered the landscape for the entrepreneur and existing business owners. Before TCJA, the C-corporation faced a top combined federal income tax rate of 50.5%, comprised of a 35% corporate tax rate and 23.8% rate on dividends. In contrast, the pass-through entity[1]had a maximum U.S. federal tax rate of 39.6%.[2]

After the TCJA came into existence, the C-corporation federal income tax rate fell from 35% to 21%. Offering a comparatively lower tax rate for C-corporations, the TCJA has motivated business owners to convert their pass-through entities to C-corporations.

Despite the decreased tax rates for C-corporations, the C-corporation may not be the best option in every scenario. The choice of entity for tax-sensitive parties depends upon several factors, such as:

State Tax: Some states may apply higher tax rates to C-corporations. However, California’s 2018 tax rate for C-corporations is 8.84% while the maximum tax rate for individuals is 12.3%.

Character of Income: Individuals who earn investment income in dividends and capital gains are subject to a 20% long-term capital gains rate and 20% rate on qualifying dividends. For these business owners, pass-through entities may prove more tax-efficient.

Qualified Business Income Deduction: Unlike C-corporations, pass-through entities can be entitled to a 20% deduction on qualified business income.

Tax on Undistributed Earnings: The C-corporation tax treatment proves preferable for undistributed earnings, since the tax rate is 21% for a C-corporation and 29.6% to 40% for a pass-through entity. Still, for C-corporations, the double taxation effect on distributed earnings can be a detractor.

Even if the C-corporation tax treatment is currently preferable, certain TCJA tax provisions expire after 2025. Further, entity choices may be driven by other considerations, such as the number of shareholders, the need for alternate classes of stock, exit factors, and business formalities.

Ultimately, when deciding on the type of entity, the taxpayer should consult an attorney who can tailor the assessment to the taxpayer’s needs. Star Q. Lopez assists clients in making critical business decisions in light of current legislation. If you wish to schedule a consultation with the author, please call (949) 301-9443 or email star@businesslawoc.com.

[1]Businesses formed as S-corporations, partnerships, or LLCs qualify as pass-through entities.

[2]Before the TCJA, the U.S. federal income tax rate for a pass-through entity’s passive business income would reach 43.4%.

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