1. IMPACT OF THE NEW TAX CUTS AND JOBS ACT ON THE CHOICE OF BUSINESS ENTITY
Presented by Martin C. Levin, CPA CVA MBA
RLB Certified Public Accountants
October 4, 2018

2. ANALYSIS PRIOR TO TAX CUT AND JOBS ACT (TCJA)
Conventional wisdom was to migrate to the lower individual rates in Pennsylvania considering the 9.99% corporate net income tax rate vs. 3.07% personal income tax rate thereby choosing the pass-through form of business (partnership, LLC or S corporation)
Double taxation of C corporation earnings resulted in an effective federal tax rate of 48% [1- ((1-.35) X .8)] adjusted to % if applying additional 3.8% NII tax
Required substantial year end tax planning for C corporations in order to mitigate corporate level income tax (via bonus arrangements, etc.)

3. ANALYSIS PRIOR TO TAX CUT AND JOBS ACT (TCJA)
Considerations included the ability to pay wages (S corporations) vs. having to take draws (Partnerships and sole proprietorships)
Considerations included the ability to participate in employee benefits plans (limitations to Section 125 for >2% shareholders)
Considerations included the calculation of wages vs. dividends for S corporation shareholders within reasonable compensation rules

4. SIGNIFICANT CHANGES AS A RESULT OF THE Tax Cuts and Jobs Act (TCJA)
Reduced C corporation tax rates from 35% to 21%
Reduced top individual tax rate from 39.6% to 37%
Allows certain pass-through entity owners to use a deduction (subject to numerous limitations) of up to 20% of their qualified business income thereby lowering their effective top tax rate to 29.6% (37% X 80%)

5. Tax Cuts and Jobs Act (TCJA)
C corporation tax cut is permanent whereas the 20% pass-through entity deduction sunsets at the end of 2025 along with the marginal tax rate decreases
TCJA reduces the ability of individuals to deduct certain taxes including state and local income, real estate taxes, etc. to $10,000. This limitation extends to taxes paid by pass-through entities
No tax deduction limitation exists for C corporations

6. Tax Analysis of the Benefits of the Pass-Through Entity vs
Tax Analysis of the Benefits of the Pass-Through Entity vs. C corporation status
Under prior law, the analysis generally took into consideration 3 different rate scenarios
C corporation rates
Pass-through entity individual rates for active participation
Pass-through entity individual rates for passive participation (due to enactment of the net investment income tax)
Under new law, the analysis must expand to include
Pass-through entity income that qualifies for the new pass- through entity deduction
Pass-through entity income that does not qualify for the new pass through entity deduction

8. New Qualified Business Income Deduction (“QBID”)
Absent this provision, the substantial tax rate differential between C corporations and the top marginal rate applicable to pass-through entity owners would make migration to C corporation status almost certain
This 20% deduction of business income applies to business related income including rent but does not extend to investment income such as interest, dividends and capital gains

9. Qualified Business Income Deduction (“QBID”)
Limitations apply including a disqualification for certain service businesses including:
Health
Law
Accounting
Actuarial Science
Performing Arts
Consulting
Athletics
Financial Services
Brokerage Services
Investing and Investment Management
Any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners
Architects and Engineers are excepted

10. Qualified Business Income Deduction (“QBID”)
Service business limitation does not apply under certain taxable income limits
$315,000 for married filing joint taxpayers
$157,500 for other non-joint filing taxpayers
The limitation is phased back in ratably up to $415,000 for joint taxpayers and $207,500 for non-joint filing taxpayers
The deduction is limited to the greater of
50% of the owner’s share of the allocable W-2 wages as reported to SSA or
25% of the owner’s share of the allocable W-2 wages as reported to SSA plus 2.5% of the original cost basis of qualified property

11. Qualified Business Income Deduction (“QBID”)
Other issues
This raises issues whereby multiple entities are operated but wages do not exist in all entities (e.g. real estate entities) as the limitation applies on an entity by entity basis
Consideration must be given to reasonable compensation of S corporation shareholder/employees to avoid running into the W- 2 wage limitation. It may now be desirable to pay wages
IRS has indicated partner and sole proprietor earnings will not qualify as wages for the QBID calculation which could make S corporation status preferable to avoid wage limitation in QBID
Losses in any year must be carried forward to the subsequent year when calculating the QBID

12. Consider the Intent of the Owners with Regard to Dividends
If entity will pay all corporate earnings out to the shareholders, the benefits of electing pass-through entity status become obvious by elimination of the double taxation impact
If the entity does not intend pay all of the corporate earnings out to the shareholders, then C corporation status may be more appropriate
The above impact is magnified if the shareholders are passive in nature and subject to the NII
Scenarios of intent to distribute earnings must be considered on a case-by-case basis depending upon the amount of dividends to be distributed

16. Consider the Intent of the Owners with Regard to the Ultimate Business Disposition (Chart 5)
Assuming no intent to pay dividends and no intent to sell the business during the owner’s lifetime, switching to C corporation status will permanently reduce income taxes
What if the intent of the owner is to sell the business within the next 8 years (consider that the legislation currently sunsets the lower individual marginal tax rates in 2026 or year 9)

17. Consider the Intent of the Owners with Regard to the Ultimate Business Disposition (Chart 5)
Even after using PV modeling, the immediate benefit of lower C corporation tax rates may be substantially reduced or eliminated entirely if plans are to sell the business
This tax differential will increase if the C corporation owners plan on dividend distributions during the holding period
Caution needs to be exercised in regard to the sunset provisions such that sales contemplated beyond 2025 will yield a different analysis based on higher individual marginal tax rates and the loss of the QBID.

19. Sales of C Corporations vs. Pass-Through Entities
The preponderance of small business sales consummated are asset rather than stock sales
Asset sales afford the buyer the opportunity to step-up the basis in the assets acquired yielding potential immediate tax deductions with regard to tangible assets acquired (this benefit is enhanced with 100% bonus depreciation)
Since a portion of the asset allocation is usually attributable to goodwill, the seller of the pass-through entity can enjoy capital gains tax treatment (ordinary rates may apply to depreciation recapture, etc.)

20. Sales of C Corporations vs. Pass-Through Entities
C corporation asset sales result in double taxation to the seller thereby making this type of sale cost prohibitive. (Tax on the assets sold inside the C corporation and tax to the shareholder upon liquidation)
Caution to sellers of assets in pass-through entities under the TCJA certain self-generated intangibles no longer enjoy capital gains treatment (e.g. patents, designs, secret formulas, copyrights)

21. Other C Corporation Considerations That Impact Dividend Paying Considerations
Accumulated earnings tax
Personal holding company tax
Unreasonable compensation issues

22. Questions and wrap-up Martin C. Levin, CPA CVA MBA RLB Accountants