Business Planning
Business entity selection after the Tax Cuts and Jobs Act of 2017
By Eva Stark, JD, LL.M.
When thinking about setting up a new business, aspiring business owners will discover that state laws recognize numerous business entities. These entities can include corporations (including professional corporations), limited liability companies (including professional LLCs or series LLCs), partnerships (including limited partnerships, limited liability partnerships, limited liability limited partnerships or general partnerships) and others. The type of activity the business will conduct, the laws governing the relationship between co-owners, and the laws governing liability and other issues between owners and third parties will all be key factors for consideration. The federal income tax treatment of the various entities will also likely rank highly on the list of issues to consider.
The Tax Cuts and Jobs Act of 2017 (TCJA)
While state law business-entity options are numerous, the options are more limited when it comes to federal income taxation. A business entity will generally be taxed as one of the following:
- C corporation,
- S corporation, or
- Partnership (if there is more than one owner) or disregarded entity (if there is a single owner).
Of these, all except the C corporation are taxed as a form of "pass-through" entity. The federal income taxation of these entities changed significantly with the TCJA, and such changes will not only affect newly created entities but existing businesses as well.
Impact on C corporations
The tax burden of many higher-income C corporations has been permanently reduced by the TCJA, but "double taxation" (taxation at the entity as well as the shareholder level) remains for all C corporations. The TCJA replaced the graduated marginal tax rates ranging from 15% to 35% with a flat rate of 21%. The TCJA also repealed the corporate alternative minimum tax. On the shareholder level, C corporation owners remain subject to a second level of taxation when income is distributed from the corporation, which can be 0%, 15% or 20%. Dividends may additionally be subject to a 3.8% tax on net investment income. As a result, even with reduced rates, C corporations remain a relatively unattractive option from an income tax perspective. This may be especially true for lower-income C corporations which previously enjoyed effective tax rates of under 21% (typically C corporations with roughly $90,000 of taxable income or less).
Impact on pass-through entities
The tax burden of the owners of certain pass-through entities has also been reduced by the TCJA, but only temporarily—until January 1st, 2026.1 Unlike C corporations, pass-through entities do not pay taxes on the entity level, although S corporations and partnerships file entity-level information returns.
The TCJA benefits the owners of pass-through entities in two ways. First, individual tax brackets have been adjusted so that income flowing through to the owners of pass-through entities is generally taxed at lower rates. Second, the TCJA created a new deduction for pass-through business income, up to the lesser of 20% of taxable income or the combined qualified business income of the taxpayer.2
Generally, owners of all pass-through entities may claim the deduction so long as they report taxable income of less than $315,000 for married filing jointly or $157,000 for all other filers. Above this income level, limitations begin to be phased in, which reduce the deduction based on (i) wages paid by the company, (ii) company assets owned and (iii) the type of business the company is engaged in (i.e., whether the business is a specified service business). Limitations fully apply once a business owner's taxable income reaches $415,000 for married filing jointly or $207,500 for single taxpayers. Without diving into the technicalities of the TCJA, the wage limitation sets a ceiling on the business income that could qualify for the 20% deduction at 50% of wages paid. The asset limitation sets a ceiling to business income that could qualify for the 20% deduction at 25% of wages paid plus 2.5% of the unadjusted basis of qualified property the business owns. On the other hand, the specified service business limitation completely eliminates the 20% deduction on qualified business income for specified service businesses (including businesses that provide health, law, engineering, accounting, actuarial science, financial, brokerage and certain other services) once the taxpayer's income reaches a level of income where the limitations are fully phased in ($415,000 for married filing jointly or $207,500 for single filers).
Choosing among pass-through entities
One of the most often-touted benefits of S corporations over other pass-through entities has been that S corporations can pay W-2 wages to owners which in turn may reduce the owners' payroll tax exposure in certain circumstances. Unlike the owners of other pass-through entities, S corporation owners are generally only subject to payroll taxes on the W-2 wages they receive—provided that the wages are reasonable. Profits an S corporation owner receives that are in excess of his or her W-2 wages are generally only subjected to income tax and escape payroll taxes. Owners of partnerships or disregarded entities, on the other hand, must generally pay payroll taxes on all of their business income.
Under the TCJA, a pass-through entity's ability to pay W-2 wages may also affect to what extent, if any, the pass-through entity may benefit from the potential 20% deduction on qualified business income. W-2 wages paid generally reduce qualified business income (resulting in a lower deduction, all else equal) but also increase the wage limitation ceiling, where such ceiling is applicable (resulting in a higher deduction, all else equal). This feature may make the disregarded entity or partnership a relatively more attractive option for certain lower-income business owners to whom the wage or asset limitations may not apply, while making the S corporation a relatively more attractive option for higher income business owners who are subject to the wage or asset limitation. The table below illustrates how W-2 wages paid may affect the potential 20% deduction on qualified business income for three types of pass-through entities.
Example of 20% Deduction for Pass-Through Entities (Lower Income vs. Higher Income)3
| Lower Income Business | ||||
| S-Corporation | Partnership | Disregarded Entity |
||
| Business income | $200,000 | $200,000 | $200,000 | |
| Wages (W-2 only) | $150,000 | N/A | N/A | |
| Guaranteed payments | N/A | $0 | N/A | |
| Net business income | $50,000 | $200,000 | $200,000 | |
| Qualified business income | $50,000 | $200,000 | $200,000 | |
| Maximum potential deduction (20% QBI) | $10,000 | $40,000 | $40,000 | |
| 50% wage limitation | N/A | N/A | N/A | |
| Potential deduction | $10,000 | $40,000 | $40,000 | |
| Higher Income Business | ||||
| S-Corporation | Partnership | Disregarded Entity |
||
| Business income | $1,000,000 | $1,000,000 | $1,000,000 | |
| Wages (W-2 only) | $400,000 | N/A | N/A | |
| Guaranteed payments | N/A | $400,000 | N/A | |
| Net business income | $600,000 | $600,000 | $1,000,000 | |
| Qualified business income | $600,000 | $600,000 | $1,000,000 | |
| Maximum potential deduction (20% QBI) | $120,000 | $120,000 | $200,000 | |
| 50% wage limitation | $200,000 | $0 | $0 | |
| Potential deduction | $120,000 | $0 | $0 | |
Conclusion
Selecting the right business entity is a difficult decision that every aspiring business owner must make. Not only must state laws be considered, but tax implications as well. Recent tax law changes may create additional complexity not only for aspiring business owners but also for the owners of existing businesses that are affected. The optimal choice of entity decision will depend on many variables, both tax and non-tax related.
As a result, before establishing a business entity or changing the tax status of an existing entity, owners should thoroughly explore such variables with an experienced attorney or CPA.
 |
Eva Stark, JD, LL.M.,joined The Nautilus Group® in 2014 to assist with the development of estate and business plans. She also performs advanced tax research. Eva graduated summa cum laude with a BS in economics and finance from The University of Texas at Dallas. She earned her JD, with honors, from Southern Methodist University, where she served as a student attorney and chief counsel at the SMU Federal Taxpayers Clinic. She received her LL.M. in taxation from Georgetown University Law Center. Prior to joining Nautilus, Eva worked in private practice in tax controversy, business law, and litigation. |
§IRC 199A pass-thru business
deduction: Applying the 28.57%
magical W-2 formula.
Estate & Gift
§IRC 199A pass-thru business
deduction: Applying the 28.57%
magical W-2 formula.
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