Since its passage in late 2017, the Tax Cuts and Jobs Act (TCJA) has given business owners and their tax advisors plenty to think about. One ongoing item of interest to contractors is whether their chosen business structure still makes sense in light of tax law reform.
What’s the deal?
The TCJA slashed federal corporate income taxes from a top rate of 35% to a flat rate of 21%. So, many construction companies organized as passthrough entities — such as S corporations, limited liability companies (LLCs) and partnerships — are rethinking their entity choices.
An owner’s share of pass-through income continues to be taxed at individual income tax rates as high as 37% (down from 39.6%), so converting to a C corporation may seem like a no-brainer. But while some businesses may benefit from converting, the decision isn’t just a matter of comparing a 37% rate to a 21% rate. There are many factors to consider in estimating your company’s net effective tax rate as a C corporation vs. its net effective rate as a pass-through entity.
Are you eligible?
The TCJA permits certain pass-through owners (including sole proprietors) to deduct 20% of their qualified business income (QBI) from the entity. (However, the deduction may not exceed20% of an owner’s taxable income excluding net capital gains.)
QBI generally means your allocable share of the company’s net income — excluding certain items, such as investment income, reasonable compensation from an S corporation and guaranteed payments from a partnership. Assuming you’re in the 37% tax bracket, receive only QBI from the company and qualify for the full deduction, your effective pass-through rate will be 29.6%. This is still higher than the corporate rate, but, given potential double taxation of corporate income, it may be enough to tip the scales in favor of pass-through status.
Is there a catch?
The pass-through deduction is subject to two important restrictions that may reduce or eliminate its benefits:
- Material participation limit. If you’re a passive investor in a pass-through entity, you may be subject to an additional 3.8% of taxation under the net investment income tax (NIIT) on your share of the company’s income. The tax applies to individuals with modified adjusted gross incomes (MAGIs) exceeding $200,000, or $250,000 for joint filers. (Typically, MAGI is the same as adjusted gross income.) It’s equal to 3.8% of the lesser of your NII or the excess of your MAGI over the income threshold.If you materially participate in a pass-through business, you’ll avoid the NIIT. But keep in mind that material participants are generally subject to self-employment taxes on their shares of partnership or LLC income or to payroll taxes on their salaries from S corporations. C corporation shareholders, on the other hand, are subject to the NIIT on dividends, regardless of their level of participation in the business.
- Profit distribution. If your construction company distributes its profits to the owners, a pass-through structure may be preferable. This is because C corporation distributions are exposed to double taxation: once at the corporate level at the 21% rate and again at the shareholder level at rates up to 23.8% (the 20% qualified dividend rate for high-income earners plus the 3.8% NIIT). Double taxation results in effective federal tax rates as high as 40%. If your company reinvests its profits into growing the business, however, double taxation may not be an issue (at least until the company is sold). But watch out for the accumulated earnings tax, which applies to retained earnings that the IRS deems to be excessive.
Even if a C corporation retains its earnings, doing so merely defers double taxation. If you sell the business, the proceeds will be taxed at the corporate level and again when distributed to shareholders. So, if you’re contemplating a sale, a pass-through structure may be preferable. Also consider how state taxes (individual and corporate) may affect your overall effective tax rate.
Who can help?
A change in business structure is a major decision. Work closely with your CPA to determine whether it’s the right move for your company.
We welcome the opportunity to put our construction industry expertise to work for you. To learn more about how our firm can help advance your success, please contact Dave Wolfenden at (302) 254-8240.