By Matthew A. Morris, LL.M., Esq.
Most recently, the entity of choice for the vast majority of small businesses has been either a sole proprietorship or one of the classic “pass-throughs”—limited liability companies, partnerships, and S corporations. Under the nascent Trump administration, however, some entrepreneurs are rethinking their choice of entity for both new and existing companies. Based on the prospect of lower corporate income tax rates, C corporations are getting renewed attention. But before any business makes a decision to either adopt or revert to (in the case of existing S corporations) C corporation status, that business’s tax advisor should carefully weigh the relative tax advantages and disadvantages of C corporation status that are likely to endure beyond the current administration.
I. ANALYSIS OF SPECIFIC PROPOSALS
Here is what we know so far about the specific corporate tax changes that President Trump has advocated:
In addition to these corporate income tax proposals, President Trump has advanced the following changes to individual income taxes:
We will address how each corporate income tax proposal would likely interact with each individual income tax proposal listed above.
A. Proposal #1: Lower the Highest Corporate Income Tax Rate from 35 Percent to 15 Percent (for C Corporations)
President Trump’s proposal to lower the highest corporate income tax rate from 35 percent to 15 percent is a game-changer, not just with respect to existing C corporations, but also with respect to certain S corporations that may wish to abandon their S corporation status. Most small businesses are deterred from C corporation status because it imposes two levels of taxation on the same income—once at the entity level when the income is earned and again at the individual level when the corporation distributes the income to its shareholders in the form of a dividend. With the highest corporate income tax rate currently at 35 percent and the highest individual tax rate on qualified dividends currently at 20 percent, the highest aggregate income tax rate is 55 percent. But if Trump is successful in reducing the corporate income tax rate to 15 percent, the highest aggregate income tax rate will be 35 percent (15 percent corporate tax and 20 percent individual income tax on dividends), which is only two points higher than Trump’s highest proposed individual income tax bracket of 33 percent.
B. Proposal #2: Reduce the Highest Individual Income Tax Rate on Pass-Through Business Income to 15 Percent (for Sole Proprietorships, LLCs, Partnerships, and S Corporations)
President Trump’s tax plan would enable owners of sole proprietorships and pass-through entities to elect to be taxed at a flat individual income tax rate of 15 percent. This special election would not be available for owners of “large” pass-through entities—those owners will have to treat the pass-through income as dividends (which would be subject to an individual income tax rate of 15 percent for most taxpayers and 20 percent for taxpayers in the highest individual income tax bracket of 33 percent).
II. THE ENDURING RISKS OF C CORPORATION STATUS: PLANNING FOR TAX CONSEQUENCES BEYOND THE TRUMP ADMINISTRATION
A reduction in the corporate tax rate to 15 percent would remove a significant disincentive to selecting C corporation status during entity formation, and may also prompt certain S corporations to abandon their S corporation status under section 1362(a). But making significant changes in advance of prospective tax legislation is risky business. The allure of potential tax savings in the immediate future can distract entrepreneurs from some important long-term economic realities. There are several situations in which a small business can be adversely affected by a decision to adopt or revert to C corporation status.
A. C Corporation Disincentive #1: Double Taxation of Earnings and Distributions Regardless of Any Reduction in Corporate Income Tax Rates
One significant disincentive for adopting C corporation status in anticipation of these proposed changes is that Trump’s tax plan would still impose double taxation and a higher aggregate income tax rate than that of a sole proprietorship or pass-through entity. Reducing both the highest corporate income tax rate from 35 to 15 percent will make a significant difference on C corporations’ income tax liability, but retaining the existing dividend rates means that distributions will still be subject to a second level of income tax at the shareholder level.
For example, if a X Co.—a C corporation—has $200,000 in net income for a particular tax year, and Mr. X as the 100 percent owner of X Co. wants to take a distribution of that same amount in the same tax year, then the aggregate tax rate on that income would be 35 percent under Trump’s proposed tax plan ($70,000 total): a 15 percent corporate income tax liability ($30,000) plus a 20 percent individual income tax liability on the $200,000 dividend distribution ($40,000). The aggregate income tax rate of 35 percent under Trump’s proposed tax plan is more than 10 points lower than the current aggregate income tax rate of 45.63 percent on the same net income and distribution (a 30.63 percent corporate income tax rate and a 15 percent individual income tax rate on the dividend distribution). However, owners of sole proprietorships and pass-through entities would still fare better under Trump’s proposed plan by paying a single flat individual income tax rate of 15 percent with no entity-level tax, which neutralizes at least one short-term tax benefit to C corporation status under the Trump administration. Furthermore, there is no guarantee that the next presidential administration will retain a corporate income tax rate of 15 percent, which suggests that there may also be significant long-term tax disadvantages associated with C corporation status.
B. C Corporation Disincentive #2: Adverse Tax Consequences Associated with Sale of a C Corporation
Another significant disadvantage to C corporation status that will likely remain unchanged under the Trump administration is that the aggregate income tax liability associated with a sale of a C corporation is significantly higher than that associated with a sale of an S corporation, regardless of how the deal is structured. If the deal is structured as a stock sale, then most S corporation shareholders will fare better than C corporation shareholders because (1) unlike S corporation shareholders, C corporation shareholders get no tax basis increase in conjunction with increased corporate profits and (2) a C corporation has to pay corporate income tax on the gains recognized from the sale of stock before distributing capital gains income to its shareholders, whereas S corporation shareholders are only responsible for a single level of individual capital gains tax. If the deal is structured as an asset sale, then the sale proceeds from a C corporation’s assets are still subject to ordinary corporate income tax rates and capital gains rates at the shareholder level, whereas the sale proceeds from an S corporation’s assets are only subject to one level of individual capital gains tax at the shareholder level.
There is no guarantee that the next Presidential administration will retain the same tax advantages for C corporations as those proposed by President Trump. If the next administration is devoted to a “fair share” corporate tax policy—similar to that advocated by Hillary Clinton during her 2016 election bid—then Trump’s corporate income tax rate of 15 percent will be low-hanging fruit for a new wave of tax reform. Small business taxpayers could easily find themselves and their earnings locked in a cumbersome and tax-disadvantaged C corporation with no clear exit strategy. Most small business owners who rely on their businesses as their main source of income would be well-advised to consider the long-term impact of C corporation status in addition to the short-term tax benefits that these businesses might enjoy under the Trump administration.
Matthew A. Morris is a Partner at Bowditch & Dewey LLP who focuses his practice on corporate and individual tax controversies; federal, state, and international tax planning; estate planning; and probate administration.