Business structure matters. If you plan on starting a small business, you will have to choose how it will be legally organized. This decision has been made a little more complex as a result of federal tax law changes made by 2017’s Tax Cuts and Jobs Act (TCJA). In fact, even owners of companies that have been operating for some time may want to evaluate whether their existing business structure puts them in the best position to benefit from the tax law changes.
C Corporations and Lower Corporate Taxes
Traditionally, owners of small businesses organized as C corporations have faced a potential double taxation issue. The corporation pays taxes on its profits, and if those profits are distributed to the owners as dividends, the dividends are taxed to the owners individually. Because dividends are not tax deductible by the corporation, corporate profits are essentially taxed twice.
Prior to the TCJA, C corporations paid federal income taxes on a graduated scale up to 35% of taxable income. Personal service corporations paid taxes at a flat 35%. The TJCA reduced the corporate income tax rate substantially — to a flat 21%. The corporate tax rate reduction is a significant benefit for C corporations and their owners. Moreover, a C corporation can fully deduct state and local income taxes, whereas the TCJA limits an individual taxpayer’s itemized deduction for state and local taxes to $10,000 ($5,000 if married filing separately).
Generally, the net taxable income from pass-through entities — S corporations, partnerships, limited liability companies (LLCs) taxed as sole proprietorships or partnerships, and sole proprietorships — is taxed to the owners individually at their regular income tax rates. With limited exceptions, a corporate-level tax does not apply.
The TCJA lowered the top regular income tax rate for individual taxpayers from 39.6% to 37% through 2025. Additionally, thanks to the TCJA, individuals who own interests in pass-through business entities may be eligible to deduct up to 20% of their qualified business income. The 20% deduction is subject to significant limitations that apply to owners at higher income levels. However, for business owners who can qualify, the 20% deduction lowers the top effective tax rate on their qualified business income to 29.6%.
To Switch or Not?
The 21% corporate income tax rate may prompt small business owners to consider switching to (or starting) a C corporation. There are various factors to weigh before making a decision. For example, switching to a C corporation may make more sense for companies that expect to reinvest capital for business needs than for companies that intend to distribute profits to shareholders in the form of taxable dividends. However, should the owners contemplate a future sale of the business, double taxation would still be a potential issue were the transaction to be structured as an asset sale.
Professional Advice Is Necessary
This is a complex issue and there are numerous variables — both tax and nontax — that will come into play. Be sure to consult your legal and tax advisors before making a move to switch to a different business structure or to select an entity type for a new business.