In my last post, I discussed some key changes of the Tax Cuts and Jobs Act that will be affecting individuals. In this post, I will discuss how the Act will impact a business owner’s decision to structure an entity as either a C corporation or an S corporation.
Part Two: Business Entities
Perhaps the most talked about changes to our tax law involve these two numbers: 21% and 20%. These numbers hold very different purposes and incentives with varying degrees of permanence.
The 21% figure represents a drop in the maximum federal corporate income tax rate (down significantly from a previous top rate of 35%). Unlike the rate changes that affect individuals and pass-through entities (which will be discussed later), this drop in the top rate is permanent.
At the heart of the Tax Cuts and Jobs Act is a pointed intention to create jobs both domestically and to bring jobs back from overseas. Congress believes that by lowering the income tax rate for C corporations, it will inject a surge of competitive energy to the U.S. economy by encouraging more business activities, investments, and operations at the corporate level. Of course, skeptics have pointed out that lowering the corporate rate to 21% is not going to make a big difference from an internationally competitive standpoint because, they point out, the foreign corporate rates are still lower than the new U.S. rate. Furthermore, nothing is stopping those foreign countries (within the constraints of those countries’ laws) from further lowering their rates to maintain a business advantage.
Nevertheless, it is undeniable that at the very least, many new and existing corporate entities will assess and make business decisions based on a dramatically lower top U.S. corporate rate than in previous years. It is worthwhile to point out that there are also numerous other changes in the law that must be taken into account when determining whether incorporating is the best option. For example, a company’s net operating losses can no longer be carried back under the new tax law and are also now limited to 80% of taxable income. However, they may be carried forward indefinitely (where the old rules allowed loss carry forwards for 20 years).
Similarly, net business interest expense has been limited to 30% of adjusted taxable income, with the definition of “adjusted taxable income” set to be more restrictive for tax years beginning in 2022 (read: unfavorable to taxpayers). However, the Act boosts a company’s ability to fully deduct qualifying property, though this boost is only fully applicable between September 27, 2017 through 2021. Beginning in 2022, that benefit will begin to phase out and will be fully phased out by the end of 2026.
It can reasonably be interpreted that while Congress wants to push businesses toward growth and production, it also imposes clearly defined constraints.
Let us now discuss the significant of that second number: 20%, which represents a newly allowable deduction on qualified business income that is earned by pass-through entities. On its face, this much-talked about deduction under Section 199A could spur growth in many industries of those businesses that elect to be taxed as flow-through entities. However, the initial excitement and buzz over this deduction has since been subdued. Although it is not entirely clear whether Congress intended to do so, this new rule indeed favors certain selected industries. I will not go into the technical mechanics of the rule but by way of example: an ideal candidate who would - and could - take advantage of the 199A deduction is a company organized as an S corporation and doing businesses in one of these industries: architecture, engineering, small breweries and distillers, farming, plumbing, mining, and restaurant. However, I would like to add one note on restaurants. As the 50% deductibility for costs incurred to entertain prospective clients is now eliminated, and as meals provided to employees are now only 50% deductible (and completely eliminated beginning 2026), how will the restaurant industry react and prepare for these changes?
How all of these new rules will unfold, and how they may impact businesses organized as C corps, S corps, LLCs, or proprietorships, is yet far from clear. What is clear is that it is the job of the tax attorney to stay up-to-date with changes in the tax law, rules and regulations, and to communicate and explain such changes to businesses and the owners that may be affected.