Entity Choice: Is It Time for a Switch?

The Tax Cuts and Jobs Act (TCJA) lowers the federal income tax rate for C corporations to a flat 21%. This fundamental change has caused some manufacturers that are set up as sole proprietorships, partnerships, S corporations or limited liability companies (LLCs) to ask whether it still makes sense to continue to operate as a so-called “pass-through” entity.

Here’s what you need to know to make an educated decision about your business structure under today’s tax law. 

Pros of C corporations

A flat 21% tax rate works to the advantage of C corporations that expect to report substantial profits. The tax rates on income from pass-throughs depend on their owners’ rates. For individual owners, income is taxed at graduated rates that top out at 37% for 2018 through 2025.   

In addition, the tax rate for C corporations has been permanently reduced under the TCJA. However, the new deduction for qualified business income (QBI) — which was designed to create tax rate parity between C corporations and pass-throughs — will expire at the end of 2025, unless Congress extends it.

Larger manufacturers also might be restricted from using pass-through structures altogether. For example, most publicly traded companies are structured as C corporations (although a few are set up as publicly traded partnerships). Your tax and legal advisors can explain which structures your business is eligible for.

Pluses for pass-throughs

It’s important to remember that pass-through entities are still only taxed once — at the owner level. Pass-throughs aren’t taxed at the entity level.

However, C corporations are still potentially taxed twice under the TCJA. First, the C corporation pays entity-level income tax. And then, corporate shareholders pay tax on dividends paid by the corporation and capital gains when shares are sold for a profit. Dividends and capital gains also may be subject to the 3.8% net investment income tax at the individual shareholder level.

Additionally, pass-through entities may qualify for the new QBI deduction. Most pass-through manufacturing businesses won’t be subject to the limitations on the QBI deduction that affect 1) service businesses, and 2) businesses with minimal W-2 wages and fixed assets. So, individual owners of pass-through manufacturing businesses will often be eligible for the maximum deduction of 20% of QBI.

If your business will report a slight profit — and you’re in the 0%, 10% or 12% individual tax bracket — your effective tax rate might be lower if your business is set up as a pass-through entity than if it’s a traditional corporation. Moreover, if your business consistently generates losses, there’s no tax advantage to operating as a C corporation. Losses from C corporations can’t be deducted by their owners. So, it’s usually better to operate as a pass-through entity and deduct the losses on your personal tax return.

In addition, C corporations are subject to complex accumulated earnings tax (AET) rules. In general, the AET rules kick in if a C corporation retains earnings beyond the reasonable needs of the business, rather than distributing them as dividends to the owners. If you prefer to stockpile cash in your company’s bank account, discuss the AET rules with a tax professional.

Run the numbers

When it comes to selecting a legal structure for your manufacturing business, there’s no universal “best” choice. The decision requires consideration of various tax and legal issues. Your professional advisors can discuss the pros and cons of each structure under today’s tax law.

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