Is it Time to Form a Corporation With the New Tax Law?

Even though the corporate tax rate may be lower than your individual rate doesn’t necessarily mean you’ll save on taxes if you incorporate.



One of the most significant (and costly) elements of the Tax Cuts and Jobs Act (HR 1, “TCJA”) enacted by Congress is the permanent reduction of the tax rate for regular “C” corporations from a top rate of 35% to a flat tax of 21% for all C corporation income. Now, for the first time in decades, corporate tax rates are substantially lower than the income tax rates paid by higher income individuals.

However, most businesses can’t take advantage of the 21% rate. This is because most people who own their own businesses, especially smaller businesses, have not formed C corporations. Instead, their businesses are owned and operated as pass-through entities: sole proprietorships, limited liability companies (LLCs) taxed as partnerships, partnerships, or S corporations (corporations taxed as pass-throughs). Such pass-through owners pay tax on their business profits at their individual tax rates, not the corporate rate.

So, if your business is a pass-through, should your form a C corporation to take advantage of the new 21% corporate rate? It depends . . . and it’s complicated.

Lower Corporate Tax Rates May Not Save You Taxes

You can compare the rates for individuals and corporations in the charts below. The top individual rate under the TCJA is 37%, 16% higher than the 21% corporation rate. Indeed, singles who earn as little as $82,500 pay income tax at a top 24% rate—3% more than the corporate rate.

C Corporation Tax Rate 2018 and Later

All Income

21%


Personal Income Tax Rates 2018- 2025

Rate

Married Filing Jointly

Individual Return

10%

$0 - $19,050

$0 - $9,525

12%

$19,050- $77,400

$9,525 - $38,700

22%

$77,400 - $165,000

$38,700 - $82,500

24%

$165,000 - $315,000

$82,500 - $157,500

32%

$315,000 - $400,000

$157,500 - $200,000

35%

$400,000 - $600,000

$200,000 - $500,000

37%

over $600,000

over $500,000

However, the fact that the corporate rate is lower than your individual income tax rate doesn’t necessarily mean you’ll save on taxes if you incorporate. There are three main reasons for this:

  • the problem of double taxation
  • you’ll be your corporation’s employee, and
  • you won’t be able to take advantage of the new pass-through tax deduction.

The Problem of Double Taxation

If you’re the owner of a C corporation, any direct payment of your corporation’s profits to you will be considered a dividend by the IRS and taxed twice. Such dividends are not deducible by the corporation. First, the corporation will pay corporate income tax on the profit at the 21% corporate rates on its own return, and then you’ll pay personal income tax on what you receive from the corporation. This is called “double taxation.”

C corporation dividends are usually taxed at capital gains rates. Higher income taxpayers must also pay a 3.8% Medicare tax on net dividend and investment income. Dividends from stock owned more than one year are taxed at the long-term capital gains rate shown in the chart below.

2018 Income If Married Filing Jointly

Tax Rate on Qualified Dividends

$77,200 or less

0

$77,201 to $250,000

15%

$250,001 to $479,000

18.8% (15% long-term capital gains rate + 3.8% Medicare tax)

All over $479,000

23.8% (20% long-term capital gains rate + 3.8% Medicare tax)

2018 Income If Single

Tax Rate on Qualified Dividends

$38,600 or less

0

$38,601 to $200,000

15%

$200,001 to $425,800

18.8% (15% long-term capital gains rate + 3.8% Medicare tax)

All over $425,800

23.8% (20% long-term capital gains rate + 3.8% Medicare tax)

Thus, for example, if you pay tax on your corporation’s dividends at the 15% rate, the total tax on every $100 distributed to you will amount to $32.85. The effective tax rate is 32.85% (21% + (79% x 15%) = 32.85%). This is less, but not that much less than the 37% top individual rate. If your income is over $479,00 if you’re married, or $425,800 if you’re single, your total tax on each $100 distributed to you would be $39.80 (21% + (79% x 23.8%) = 39.8%), more than the 37% top individual rate.

So, depending on your business income, the total tax you’d have to pay on distributions from your C corporation could be more than you would pay if your business is a pass-through entity and you pay one level of tax on all your business profits at your individual income tax rate.

You’ll Be an Employee of Your Corporation

When you form a C corporation and actively work in the business, you must become your corporation’s employee. Your corporation must pay you reasonable employee compensation for your work. You must pay tax on your employee salary, bonus, and other taxable payments from your corporation at your individual tax rates. The corporation gets to deduct employee salaries and benefits from its taxable income, so there is no double taxation on these payments, but there is no tax savings either.

However, becoming an employee of your C corporation isn't all bad. The tax law allows a C corporation to provide its employees with many types of fringe benefits that it can deduct from the corporation’s income as a business expense. But the employees need not include the value of the fringe benefits in their taxable income, effectively making them tax free. This can save substantial taxes. No other business entity can do this. Possible tax-free employee fringe benefits include:
 health, accident, and dental insurance for you and your family, disability insurance, reimbursement of medical expenses not covered by insurance, deferred compensation plans
, working condition fringe benefits such as company-owned cars, and group term life insurance.

No Pass-through Tax Deduction for C Corporations

The TCJA created a brand new tax deduction for pass-through entities. The owner of a pass-through can deduct an amount equal to 20% of the net income from the entity—for example, if your net income from your sole proprietorship or LLC business is $100,000, you get to deduct $20,000 from your income taxes. However, this deduction is phased out if your total taxable income from all sources is over $315,00 if you’re married filing jointly or $157,500 if you’re single. The 20% deduction ends if your business income is over $415,000 for marrieds and $207,500. If you’re in a service business, you get no pass-through deduction at all if your income exceeds these thresholds.

If you’re not in a service business, and your income exceeds the threshold, your deduction is limited to 50% of the amount you pay your employees, or 25% of employee payments plus 2.5% of the value of your depreciable business property.

If you qualify for the full 20% pass-through deduction, the effective tax rate pay on your pass-through income will be much lower than the individual rates for nonpass-through income, as shown in the following chart:

Non-Passthrough Income Tax Rates

Effective Passthrough Income Tax Rates (after 20% deduction)

10%

8%

12%

9.6%

22%

17.6%

24%

19.2%

32%

25.6%

35%

28%

37%

29.6%

C corporations do not benefit from the 20% pass-through tax deduction. If you’re married and qualify for the 20% deduction, you could earn up to $315,000 in pass-through income and pay tax at less than the 21% C corporation rate.

The Bottom Line

If you’re making more than $415,000 in profit from your business each year ($207,500 if you’re single), being taxed as a C corporation might benefit you, especially if you’re in a service business and can’t use the 20% pass-through deduction. C corporation taxation can be particularly beneficial if you’re able to keep a substantial amount of income in your business—that is, you don’t distribute it to yourself in the form of dividends or employee compensation. Money you keep in your C corporation business is taxed only once at the 21% rate. Otherwise, there might not be much benefit at all to C corporation taxation. However, don’t do anything without consulting your accountant and have him or her run the numbers for you. If C corporation tax treatment looks good, you don’t necessarily have to form a corporation to benefit. If you already have an LLC, partnership, or limited liability partnership (LLP), you can elect to have it taxed as a C corporation by filing a form with the IRS. This enables you to obtain the benefits of C corporation tax treatment without going to the trouble of actually forming a corporation.

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