The 2017 tax reform ended up in the first significant changes in the field since the Tax Reform Act of 1986. In general, the Tax Cuts and Jobs Act (TCJA) of 2017 decreased the corporate income tax rate by 15% (from 35 to 21%). Analysts expected that this headline change would drive the conversion of flow-through entities and partnerships into C corporations (Klinzing, 2019). Nevertheless, the trend of three consecutive years shows that it has not occurred.
Although TCJA lowered the federal corporate tax rate for enterprises with a C Corporation structure, the distributions’ taxation (dividends) remain at the same level. For instance, noncorporate shareholders should pay 23.8% federal income tax on dividends. After adding the state’s income tax, the number grows to 39.8%, making C Corporations unattractive. The initial goal of reform was to increase profits of multinational corporations spurring capital investments. In practice, such businesses opted to buy back shares of their own stock seeking short-term profits.
On the contrary, a flow-through entity avoids double taxation as it itself is not subject to taxation. Nevertheless, its owners and investors should pay income tax that dropped by 2%. Noncorporate taxpayers that own proprietorships, partnerships, or S Corporations enjoy a 20% deduction resulting in 29.6% of the effective federal tax rate (Klinzing, 2019). The sufficient income tax of pass-through entities depends on employment taxes, self-employment, and the net investment income tax.
In general, there is no ideal entity consideration for businesses, as everything depends on their intention to make distributions or its absence. If the company wants to reinvest the lion’s heart of its income (after-tax proceeds), a C Corporation becomes a superior growth option. It is better because of usually higher income compared to pass-through structures. Contrary, if an enterprise wants to pay dividends, the flow-through entity would be a more efficient choice. For instance, manufacturing companies should convert into C Corporation entity as it needs continuous reinvestment in R&D, equipment, and structures to grow. Due to reform’s complexity, CPA firms witnessed the surge in clients and expanded their personnel to meet the demand.
Reference
Klinzing, M. (2019). Choice of entity considerations post-tax reform: Corporation or flow-through entity?. JD Supra. Web.