Changing Entity Structure May Help Manufacturers Take Advantage of Tax Reform
Final tax reform legislation has been signed into law, bringing significant individual and business tax rate modifications that may prompt manufacturers and distributors to reconsider their entity structure. But before you abandon your choice of business entity from a tax perspective, you should carefully contemplate several factors.
It’s important to understand the notable provisions of the Tax Cuts and Jobs Act that change tax rates for individuals, C corporations, and pass-through entities.
- Individual tax rates are temporarily reduced, with the top rate lowered from 39.6 percent to 37 percent. The top individual rate applies to taxable incomes exceeding $500,000 for single filers and $600,000 for joint filers. These individual rates will sunset after December 31, 2025.
- The corporate rate is lowered from 35 percent to 21 percent beginning January 1, 2018. This is the largest reduction in the U.S. corporate tax rate in our nation’s history.
- A 20 percent tax deduction generally applies to income generated from manufacturing and distribution businesses organized as S corporations, partnerships, and sole proprietorships. For individuals with more than $157,500 ($315,000 for joint filers) of taxable income, the amount of the deduction cannot exceed the greater of (i) 50 percent of wages paid by the business and (ii) 25 percent of wages paid by the business plus 2.5 percent of the cost of depreciable business assets. The deduction reduces the effective marginal tax rate for many Main Street job creators to no more than 29.6 percent.
Given the new low corporate rate, you may be wondering if it would be preferential to be taxed as a C corporation rather than as a pass-through entity. To help you weigh your options, we will compare after-tax cash flow to shareholders of an S corporation and a C corporation in the following three scenarios, all fairly common to businesses in the manufacturing and distribution industries:
- Reinvestment of earnings followed by a shareholder distribution
- Sale of intangible assets and liquidation of corporation
- Sale of intangible assets and liquidation of corporation with qualified small business stock exclusion
Scenario 1: Reinvestment of earnings followed by a shareholder distribution
On the surface, a potential change from a pass-through entity to a C corporation structure appears attractive to those who wish to reinvest profits into the business; a C corporation can clearly accumulate more capital and expand its operations faster with a 21 percent annual tax cost, as opposed to the 29.6 percent income tax generally levied on pass-through entities. Where corporate earnings are reinvested in productive assets and the earnings are distributed far into the future, the C corporation structure may provide a better after-tax cash flow result on a present value basis. But, as Table 1 shows, if the owners withdraw after-tax earnings of the corporation in relatively short order, the S corporation may provide better after-tax cash flow to the shareholders when taking into account the shareholder-level tax imposed on C corporation dividends.
While this is a simple example, the impact is pretty clear. If the earnings are invested back into the corporation, it will have more after-tax funds to reinvest, temporarily. The impact of the double taxation is delayed until the subsequent year when the earnings are extracted from the corporation.
This example does not contemplate additional factors, including the deductibility of state taxes inside the C corporation, which are now severely limited to individuals under the new tax legislation, making the reinvestment strategy even more compelling. State tax considerations, along with plans to reinvest earnings rather than distribute proceeds to the shareholder, would have to be considered to fully model the impact.
Scenario 2: Sale of intangible assets and liquidation of corporation
It’s also important to consider the long-term plans for the business owner. It is estimated that $11 trillion of wealth will be transferred from one generation to the next over the coming several years. Managing the tax impact of a business exit is critical to optimizing the business owner’s after-tax retirement nest egg. The effect of a double tax structure could be significantly less beneficial when you stand to earn sizable gains from the sale of business assets, including intangibles. As you can see in Table 2, the pass-through entity structure actually yields a better result. (Please note that this example assumes material participation by the S corporation owner.)
While this illustrates the eventual cost to the C corporation shareholder on the sale or liquidation of the stock, it may still make sense to use a C corporation structure when the sale or liquidation event is clearly far into the future, or where intangible value can be attributed to the personal relationships of the business owner, allowing sale of “personal goodwill” directly by the owner in a manner that escapes double taxation.
Scenario 3: Sale of intangible assets and liquidation of corporation with QSB exclusion
Scenario 2 illustrates the cost of the shareholder-level tax that is generally imposed upon the sale or liquidation of a C corporation. In some instances, the shareholder may be able to exclude all or part of the gain from the sale of qualified small business (QSB) stock, eliminating the shareholder-level tax and putting C corporations and S corporations on a more level playing field when it comes to the sale of a business. Several criteria must be satisfied for gain to be excluded, including the following:
- The stock must be acquired directly from a corporation while the corporation is a C corporation. Stock acquired from other shareholders or while the corporation was an S corporation will not qualify.
- The corporation cannot have more than $50 million in assets at any time before or immediately after the investment.
- At least 80 percent of the corporation’s assets must be devoted to a qualifying business, including manufacturing and distribution.
- The stock must have been held for at least 5 years.
Outstanding stock at the time an S corporation converts to a C corporation is not QSB stock-eligible for the exclusion, but stock issued by the corporation after it becomes a C corporation may qualify as QSB stock. A switch to a C corporation could be compelling if the company is going to issue significant additional stock.
New businesses that are qualified small businesses may benefit from a C corporation structure since corporate earnings can be reinvested at a lower tax cost than with an S corporation (21 percent for a C corporation versus. 29.6 percent top rate for an S corporation) without imposing a second level of tax on the shareholders when the corporation eventually sells its assets and liquidates, as illustrated in Table 3.
Remember, these changes aren’t written in stone
Running the numbers is enlightening, but when contemplating this decision, several factors should also be included in the modeling and analysis, including:
- Whether earnings will be distributed to owners or reinvested to fund future growth
- Whether the corporation holds appreciating assets, like real estate or intangible assets
- The business exit strategy and timeline for owner(s)
- Whether the second level of tax in a C corporation can be managed (for example by taking advantage of the gain exclusion for QSB stock, by using reasonable shareholder compensation in a C corporation as a mechanism to draw earnings out of the business, etc.)
- Impact of state taxes on overall after-tax cash flow
It’s also helpful to keep in mind that this legislation isn’t permanent. The law as written sunsets the individual and tax-favored pass-through rates after December 31, 2025. And while the corporate rates do not have a sunset provision, this bill did not get bipartisan support; a change in congressional control could reverse or alter the tax rates. If you switch to a C corporation and the corporate rate rises, getting back to pass-through taxation could be challenging.
How we can help
Modeling the impact of an entity structure change is a worthwhile exercise, especially in light of all the variables. CLA’s manufacturing and distribution professionals have developed tools to help business owners like you evaluate your entity structure and develop a tax-advantaged strategy.