Choosing the Right Legal Entity Under the New Tax Law

By Cliff Ennico

January 2, 2018 7 min read

It's official.

Except for a handful of provisions that have later effective dates, the nearly 1,100-page Tax Cuts and Jobs Act is now the law of the land.

A ton of ink has already been spilled about the act's impact on small business, but the big question for most of my readers is: Should I change from my current legal entity to another to take advantage of the lower tax rates promised by the act's proponents?

Short Answer No. 1: Talk to your accountant or tax advisor.

With a single exception — the reduction of the top tax rate on regular or C corporations from 35 percent to 21 percent — virtually all of the small-business tax cuts made by the act come with a host of "ifs," "ands" and "buts." Someone (preferably a tax professional) will need to sit down and crunch your business's numbers to determine whether you should switch your legal status or stay as you are.

Short Answer No. 2: Unless there is a compelling economic reason to change status, stay as you are.

Having said that, here are a couple of personal ruminations that should not be relied on as tax advice:

C Corporations Versus Pass-Throughs. Despite the much lower tax rates for C corporations, I don't see a lot of small businesses switching from pass-through entity types, such as limited liability companies and subchapter S corporations, to C corporation status for two reasons.

First, a C corporation's income is taxed twice — once at the corporate level and then a second time when distributed to individual shareholders. That second tax is at the shareholder's individual tax rate, which for many business owners will top out at 37 percent (slightly less than the previous 39.6 percent rate). While existing C corporations will benefit greatly from the tax reduction at both levels, the advantage for pass-through entities that newly convert to C corporation status won't be as clear. The single level of taxation for pass-throughs, especially those that can benefit from the new 20 percent deduction for self-employment income (see below), may actually result in a lower overall tax rate than a doubly taxed C corporation that distributes most of its income to shareholders.

Second, and more significantly, C corporations are lots more complex to operate than pass-throughs and require considerably more legal compliance and paperwork. For example, a single-member LLC converting to a C corporation will now have to do the following:

—File the complex IRS Form 1120 rather than the relatively simple Schedule C.

—Document business decisions made "outside the ordinary course of business" with formal resolutions of the directors and shareholders, even if they all occupy the same human body.

Any marginal tax benefit from switching to a C corporation will have to be weighed against these (possibly) higher legal and tax compliance costs.

LLC Versus Subchapter S Corporation. This decision has never been easy and been made more complicated by the act.

For small businesses other than professional service firms, the 20 percent deduction from net income created by the act applies to both LLCs and S-corps, but the deduction for S-corps applies only to that portion of business income that qualifies as distribution of profit rather than salary (S-corp shareholders divide their income between salary and distribution of profit in order to reduce their FICA and Medicare tax liability). Accordingly, there may be a slight — slight — incentive for a small business organized as an S-corp to convert into an LLC, as that would extend the 20 percent deduction to 100 percent of the company's income.

Before doing that, however, think about the following:

—The cost of liquidating the S-corp and contributing the resulting capital to a newly formed LLC may be greater than the tax savings generated by the conversion.

—The 20 percent deduction for pass-throughs is scheduled to expire in 2025, or maybe sooner if the Democrats recapture Congress in 2018 and change everything again.

For professional service firms organized as sole proprietorships or single-member LLCs that are at or slightly above the income ceilings for the 20 percent deduction ($157,500 for single taxpayers and $315,000 for married couples filing jointly), there may be a slight — slight — incentive to switch to an S-corp and take a small salary, thereby saving some money on FICA and Medicare taxes (on the portion treated as salary) and ensuring that your remaining income (treated as a distribution of profit) will qualify for the 20 percent deduction.

But again, if the additional cost of filing S-corp tax returns and dealing with the complexity of operating in corporate form exceeds the tax savings, fuhgeddaboudit. Also, you just know the IRS will be auditing professional-service S-corps that get too creative, since accountants and lawyers cannot claim ignorance as a defense.

High-Tax States Versus Low-Tax States. For many pass-through businesses, the biggest tax savings under the act may come not from changing their legal status but moving from a high-tax state to a low- or no-tax state, if possible. Under the act, deductions for state and local income, and sales and property taxes are capped at $10,000. Businesses in high-tax states in the Northeast especially may well be migrating soon to Florida, Nevada and Texas, where the sun shines brightly — and there are no state income taxes.

Cliff Ennico ([email protected]) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.

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