How does the Tax Cuts and Jobs Act of 2017 (TCJA) affect small business owners? According to Borden, the new corporate tax rate and new deduction for qualified business income in the TCJA greatly complicates the choice-of-entity landscape. Prior to the TCJA, businessmen could choose between corporations and hybrid passthrough entities that combined the benefits of limited liability and one level tax. Marginal corporate income tax rates were close to those of individuals, but the taxation of dividends increased the effective corporate tax rates higher than the individual rate across all income levels. Thus, for the majority of small businesses the ideal choice-of-entity was the passthrough structure. Yet, Borden claims that the TCJA nullifies this general rule by muddling choice-of entity considerations for small businesses and entails more tax planning in order to get the most favorable effective tax rates. Post-TCJA, choice-of-entity decisions will be more nuanced, on a case-by-case basis, and preferences will likely be highly situational.
This Article continues Borden’s work earlier this year titled Choice-of-Entity Decisions Under the New Tax Act that compared the effect of TCJA on $500,000 of ordinary income earned by a corporation, a passthrough as qualified business income, or a passthrough as income from a specified service trade or business. That paper anticipated that the choice between passthrough entity and corporation will be affected by the amount of income that the owner withdraws from the business and the amount of income the business generates.
This Article continues and exemplifies the effect of TCJA by comparing the effective tax rates of different entity choices on business income at or below the $1,000,000 level (of which the majority of small business owners report) before and after the enactment of the TCJA. At those levels, the effective tax rates on passthrough income are noticeably lower than the effective tax rates on distributed corporate income. The Article presents several data tables with computed effective tax rates on taxable income at $50,000 increments ranging from $100,000 to $14,000,000 of pre-wage income. It then focuses on several types of organizational forms: corporation that pays reasonable owner compensation and distributes all of its after-tax income, corporation that pays reasonable owner compensation and distributes a fraction of its after-tax income, an S corporation that pays reasonable compensation to shareholders, a passthrough entity other than an S corporation, and a combination of basic ownership structures. It illustrates the uncertain nature of current choice-of- entity considerations due to the effective tax rate on business income varying from 21.36% to 34.60%. This is attributable to the operation of marginal v. effective tax rates, employment taxes (Social Security and Medicare), tax on net investment income (as imposed e.g. on dividends in excess of $250,000), as well as the type of business and the entity structure.
The Article points out that the effective tax rates that applied prior to the enactment of the TCJA, were only compared between corporations and passthroughs, where passthrough income was not bifurcated between different types of passthrough businesses. The effective tax rate on passthrough income then, was always less than the effective tax rate on corporate income. Yet, after the enactment of the TCJA, for most individual business owners, the most favorable tax rates apply to income from qualified business income and specialized trades and businesses. Only as income gets fairly large do corporate rates become more attractive than the passthrough rates. For most small business owners, however, the highest effective tax rates are usually irrelevant.
Accordingly, Borden suggests that the most advantageous effective tax rates for small businesses derive from a combination of C corporation and passthrough organizational choices. He then compared these choices to a combination of the structures and demonstrated that rate variations based upon entity combinations can cause subtle, carefully calculated, shifts in choice-of-entity. He concludes that the multiple tax rates under the TCJA obscure choice-of-entity analyses for small businessmen by making them dependent on the situation of the business and encourage combinations of various types of entities.
This Article's significant contribution is reminding us that while top marginal tax rates are important to notice as the rate applies on additional income or available deductions, choice-of-entity decisions are more noteworthy as they affect all tax items that flow into the business, and the business effective tax rates. It continues a long history of tax analyses that followed major tax reforms and looked at the effect of such reforms on effective tax rates and the motivation to shift from C-corporations to hybrid entities. The Article could make an even greater contribution to the current tax literature by pronouncing more that the aftermath of the TCJA on tax policy considerations of neutrality/efficiency as well as fairness/equality, simplicity, and the administrability of our tax system. For many, ideal choice-of entity after the TCJA may become the combination of various entities to get the benefits of the lower corporate rate with the advantages of the passthrough deduction. This increases the role of taxation (rather than economics) in the organizational choice that greatly affects many non-tax consequences. Moreover, such decisions will increase transaction costs for both taxpayers and the IRS that administers such rules. Organizational choices, more so than ever before, will necessitate personal consultation with a tax expert that will identify and tailor the structure to the owner’s preferences and include transition rules. A more sophisticated analysis will be required and the quick (but rather simple) online platforms of creating new LLCs will not suffice anymore. Lastly, decisions to change organizational forms will now require more detailed analysis and probably will result in a much more expensive tax planning than prior to the TCJA. Taxpayers who can afford legal advice and the fees to get the best tax results will be better off than those who cannot.