Since 1986, due to the changes made by the Tax Reform Act of 1986, the general trend has been to own and operate a trade or business through a “pass-through” entity (i.e., an S corporation or a limited liability company taxed as a partnership). Although many changes to the Tax Code have occurred since 1986, none of these changes have modified the general preference of the pass-through entity as the tax entity of choice. For these reasons, if you own a business, it is likely you own it through a pass-through entity. The changes made by the Tax Reform Act of 2017 (the “2017 Act”) necessitate that every business owner reconsider whether the pass-through entity remains the best choice for his or her business. These changes are effective January 1, 2018, and retroactive elections to change the tax classification of an entity as of such date are generally required to be made on or before March 15, 2018. Thus, time is of the essence.
As you may have heard, the 2017 Act contains a new provision which provides a 20% exclusion of pass-through income for certain owners of pass-through entities. At first blush, and viewed in isolation, one might think that this new provision would further cement the pass-through entity as the entity of choice for business owners. However, as you drill down on the details of the new provision, and consider certain other changes made by the 2017 Act, in many cases, the C-Corporation may prove to be a more tax-efficient entity. While there are many factors to take into consideration in determining whether a C-Corporation or a pass-through entity is best for a particular business owner, historically, one critical factor is the difference in the corporate tax rate and the rate at which pass-through income is taxed. Even assuming you can take advantage of the new 20% exclusion, the maximum tax rate on pass-through income will still be greater than the 21% corporate rate. This spread substantially increases in the event a pass-through business owner cannot qualify for the 20% exclusion due to the various limitations built into the new provision.
Oftentimes there is no right or wrong determination when considering the tax classification of your business entity. The analysis is complex, involves the consideration of multiple short-term and long-term considerations, and necessarily requires certain assumptions to be made. However, due to the substantial changes made by the 2017 Act, the tax classification of your business entity should be re-examined under the new rules to ensure the most tax-efficient structure.