Tax Reform & Choice of Entity Considerations

The information in BDO alerts is dependent on tax policies at the time they are published. The subject matter of this alert has since been updated. To find the latest information on this topic, read Final Regulations of Section 199A and Guidance Regarding Trade or Business Determination for Section 199A.

All pass-through entities, including partnerships and S corporations, should evaluate their choice of entity as a result of tax reform and the new reduced corporate tax rate of 21 percent (previously 35 percent). Converting from a pass-through entity to a C corporation requires thoughtful consideration, analysis, and planning.

 

WHY CHOICE OF ENTITY?

1. The new corporate tax rate of 21 percent is significantly lower than the individual tax rates, now having a maximum rate ranging from 29.6 percent to 37 percent. Because of this difference in tax rates, a C corporation entity should have more after-tax cash available to re-invest, creating incrementally greater value to its owners as compared to a pass-through entity. 
2. The effective tax rate differential between corporate and pass-through entities has been significantly reduced.  This has created an environment where even with two levels of taxation, a C corporation structure may generate greater after-tax cash value to its owners as compared to a pass through entity. 
3. Companies have a fiduciary responsibility to their shareholders and partners to evaluate their choice of entity given the significant changes outlined in tax reform legislation.

 

WHAT ARE THE KEY FACTORS TO CONSIDER?

1. Taxable Income

Inherent in considerations to structure companies in a tax efficient manner is an expectation that the company plans to generate current and future income that will be subject to taxation.

 

2. Section 199A

The Section 199A Deduction may reduce a pass-through owner’s maximum individual effective tax rate from 37 percent to 29.6 percent. It is critical to begin evaluating the extent the pass-through owner will be eligible for this deduction as part of the Choice of Entity analysis. More information can be found here.

 

3. Future Plans:  Reinvest or Distribute

The ability to generate incremental revenue and value on reinvested cash favors a corporate entity, due to the lower initial tax liability. It’s important to evaluate whether a company plans on reinvesting or distributing their after-tax cash, as this may significantly impact the overall effective tax rates.

 

4. Domestic Tax Reform  

Impact of other tax reform provisions on the company’s overall income tax liability may increase the benefits of an entity change. For instance, tax reform changes have affected rules surrounding the amount and timing of income recognition. A company may benefit from these changes via selecting more advantageous accounting methods following a change in entity.

 

5. International Tax Reform

International tax reform has created a number of complexities that may result in significant incremental tax burdens to a pass-through entity as compared to a corporate entity. These potential tax liabilities may significantly impact the overall effective tax rates. More information can be found here.
 
BDO has developed a Choice of Entity Tool to help businesses evaluate their options. The process can be as simple as a short conversation or a more in-depth, phased approach. Contact a member of the team below to determine whether a choice of entity change is the right approach for your business.

 

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