The recently enacted Tax Cuts and Jobs Act significantly changed the federal income tax landscape for all businesses beginning in 2018. The tax rate on the income of C corporations dropped from a top marginal rate of 35% to a flat rate of 21%. And if distributed to shareholders, that income would be subject to a total effective maximum tax rate of 36.8%.* The new top individual tax rate applicable to income of passthru entities (like LLCs taxed as partnerships) is 37%. While that individual tax rate on passthru income approximates the effective rate on C corporation income distributed to stockholders, some businesses will benefit from a new 20% deduction on “qualified business income,” reducing the effective rate on pass-through income to as low as 29.6%. In light of these federal income tax rate changes, many in the business community are actively deciding whether a change in tax classification—such as electing C corporation taxation for an LLC—would yield higher after-tax profits. In one recent and well-publicized decision, KKR & Co. L.P. (NYSE: KKR), a private equity firm taxed as a partnership, announced that it will convert to a C corporation.
But a change in the federal tax rates is only one, albeit crucial, decision point in evaluating a tax classification conversion. State income taxes significantly affect the overall tax on C corporations. Additionally, heavy tax burdens will be placed upon a business that subsequently decides to convert back to a passthru entity if, for example, tax rates on C corporations rise again. On the other hand, some of the Tax Act’s rules applicable to passthru entities, may be a disadvantage to some business. For example, unlike with C corporations, deduction for state income taxes paid by the owners of the passthru, along with other state and local tax payments, is now capped at $10,000 under the new Tax Act. And the 20% deduction on qualified business income may not be available in many cases or, if available, may be significantly reduced.
As is evident from this brief discussion, planning for optimal tax outcomes after the new Tax Act cannot occur in a theoretical vacuum. Rather, each business’s particular facts and circumstances must be reviewed. Therefore, we recommend that our business clients contact their advisors to discuss how the new Tax Act will affect them. As we are almost halfway through the first year of the Tax Act, the time for this analysis is now.
* The tax rates mentioned in this article all exclude the 3.8% tax on net investment income (commonly referred to as the “Obamacare” tax).