On September 13, 2021, the House Ways and Means Committee released proposed tax changes. These changes are a part of a reconciliation bill known as the “Build America Back Better” act. At the time of publication, the size and scope of the reconciliation bill are under negotiation. It is unclear if a reconciliation bill will pass this fall. Although it is likely items in the September 13 release will change, proposed tax changes to small and medium corporations could cause taxpayers to reconsider C corporations when looking at entity selection.
The purpose of entity selection is to choose an entity that best matches the goals and objectives of the business. Optimal tax rates, ownership structure, and compliance are common considerations when deciding between a C corporation, S corporation, or partnership (including a disregarded entity). Immediately after the Tax Cut and Jobs Act (TCJA) was passed under the Trump administration, there was a trend for entities to select S corporation or partnership because of the qualified business income (QBI) deduction (Section 199A). Although the proposed tax changes do not repeal the Section 199A deduction, they do limit the maximum allowed deduction. Limiting the Section 199A deduction, along with higher taxes proposed at the individual level, could increase the effective tax rate for pass-through entities.
Proposed Tax Changes for Individuals
With few exceptions, income tax for S corporations and partnerships is not determined at the entity level. Instead, these entities pass income through to the owners, and tax is determined at the owner level. For most small businesses, tax is calculated and assessed on an individual income tax return. The proposed tax changes released on September 13 increase taxes for married filing joint (MFJ) taxpayers with more than $450,000 of taxable income. The table below compares proposed tax changes at the individual level to existing law.
It is easy to see the proposed expansion of income subject to tax at higher rates at the individual level. In addition, income for S corporations and partnerships is subject to tax on the owner’s tax returns whether the income is distributed or retained in the business. This is not true for C corporations.
Income from a C corporation is taxed twice before it becomes after-tax cash in the hands of the owners. Income is taxed once at the corporate level and a second time at the individual level when earnings are distributed as a dividend. If income is not distributed then it is only taxed once at the corporate level. The corporation can spend the retained earnings in subsequent years.
The table below compares proposed and existing corporate tax rates and individual income tax rates on qualified dividends.
Why C Corporations Deserve a Second Look
Under the proposed tax changes, business owners of profitable S corporations and partnerships that are subject to higher taxes on the individual return are subject to these taxes even if the earnings stay in the business for future investment. Many businesses want to retain cash for future investment or to pay down debt. If this is an objective, the business could minimize taxes in the short term through a C corporation. Small to medium C corporations could be subject to a lower marginal tax rate than an individual. The corporation can also target the lower tax rates on the individual’s return through wages and dividends.
The proposed tax changes from September 13 increase individual income taxes for married filing joint taxpayers with taxable income over $450,000. At the same time, they propose lowering corporate tax rates for corporations with taxable income of $400,000 or less. They also propose not changing the rate for taxable income between $400,000 and $5,000,000. For this reason, if passed, the proposed tax changes would cause some taxpayers to reconsider C corporations for their business entity type.
This article was written by Steven Johnson, CPA and Shareholder in our Helena office location.