Changes to C Corporation Taxation Under the Tax Act
The Tax Act contains a number of significant changes to how C corporations are taxed, most of which will have the effect of making a C corporation a more attractive entity choice for conducting a business.
Corporate Rate Reduction
The most significant change to C corporation taxation is, of course, the major reduction in the corporate tax rate (i.e., the first level of tax in the C corporation “double tax”). Effective for the 2018 tax year, the corporate rate has been reduced from 35 percent to 21 percent. Coupled with the 23.8 percent tax on corporate dividends and liquidating distributions (which does not change under the Tax Act), the effective blended tax rate for immediately-distributed corporate profits has now been reduced from more than 50% before the Act to approximately 39.8% today (i.e., 100% minus (79% x 76.2%)). While a 39.8% rate is still much higher than the 29.6% flow-thru rate described above, under many circumstances, the effective C corporation tax rate may actually end up being lower than the rate at which flow-thru entities are taxed.
First, as noted above, the reduction of the top individual rate to 37% is only temporary, and it reverts to 39.6% after 2025 without further Congressional action. In addition, the special 20% deduction that allows a flow-thru entity to reduce its maximum tax rate to 29.6% is subject to significant limitations based on the nature of the business being conducted and the amount of wages paid and/or assets owned by the business. Thus, in many circumstances (and depending upon the nature of the business), the full 20 percent flow-thru deduction may not be available, which will have the effect of increasing the tax rate on a flow-thru business to an amount higher than 29.6%.
More importantly, with a C corporation structure, a taxpayer may have significant control over when the second, shareholder level of tax is actually incurred. To the extent that distributions of profits to shareholders can be delayed for a significant period of time, the actual effect of the second level of tax can be greatly reduced, in certain cases to almost zero. The most obvious way to delay the shareholder level of tax is by reinvesting profits back into the operation of the business, something that usually makes business sense even without considering any tax advantages of doing so. Likewise, if a taxpayer owning C corporation stock can avoid distributing profits until he or she dies and receives a step up in the stock’s adjusted basis, it may be possible to avoid the second level of tax altogether. In addition, more creative methods for delaying corporate dividend distributions will almost certainly be resurrected from back in the days prior to 1981 when individual tax rates were much higher than corporate tax rates. In this regard, however, the IRS tools for combatting such deferral efforts (most notably, the personal holding company tax and the accumulated earnings tax) are likely to acquire newfound importance as well.
Finally, it should be noted that taxpayers will be permitted to continue to take advantage of existing rules that allow up to a 100% exclusion on the gain from the sale of certain stock of a corporation that has less than $50 million of gross assets. This exclusion seems likely to become more important now that C corporations appear to be a more attractive type of structure for small, non-publicly traded businesses.
Alternative Minimum Tax Changes
Another change that is likely to make the C corporation structure look more attractive in the future is the complete elimination of the corporate alternative minimum tax. In contrast, the individual alternative minimum tax, which will continue to apply to individual owners of interests in flow-thru entities, will remain in place, although exemption levels have been increased so that fewer individual taxpayers will be subject to the alternative minimum tax in the future.
Accounting Method Changes
Yet another change under the Tax Act that may make C corporations somewhat more attractive is a provision designed to expand the number of businesses that can use the cash method of accounting for determining their annual tax obligations. For profitable businesses (i.e., those businesses where receivables generally exceed payables), the cash method of accounting is usually a more favorable method than the accrual method of accounting. However, prior to the Tax Act, a C corporation (or a partnership with a C corporation partner) was permitted to use the cash method of accounting only if (i) it had average annual gross receipts of $5 million or less; and (ii) it was not required to maintain inventories in operating its business. Under the Tax Act, C corporations can now use the cash method of accounting, regardless of whether or not they use inventories, so long as their average annual gross receipts do not exceed $25 million.
Advantages of Using a C Corporation Under the New International Tax Regime
One of the most significant changes made by the Tax Act is the movement of the United States from a so-called “worldwide” tax system (where U.S. taxpayers are taxed on all their profits regardless of where those profits are generated) towards a modified “territorial” system (where profits attributable to operations in foreign countries are not subject to U.S. tax, even when repatriated). This major change in the structure of the international tax provisions is accomplished by providing domestic C corporations with a 100 percent “dividends received deduction” on dividends from foreign subsidiaries that conduct active businesses outside the U.S. The new rules are subject to a number of special exceptions, including a special new tax on global intangible income. Likewise, U.S. taxpayers will continue to be subject to the existing “subpart F” rules that provide for immediate U.S. taxation of passive income and certain related party active income earned by controlled foreign subsidiaries.
In any event, the new 100 percent dividends received deduction will be available only to companies that conduct their U.S. operations in C corporation form. U.S. partnerships and S corporations with foreign subsidiaries will continue to be subject to U.S. tax when the earnings of their foreign affiliates are brought back into the United States. In short, the new territorial regime for international taxation provides a strong incentive for any domestic company with foreign operations to be structured as a C corporation rather than as a flow-thru entity.
For more information on this topic, please contact:
Denver Mike Dubetz 303.299.8464 email@example.com
Denver Steven Miller 303.299.8144 firstname.lastname@example.org
Denver John Birkeland 303.299.8225 email@example.com
Aspen Joe Krabacher 970.300.0123 firstname.lastname@example.org
Sherman & Howard has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and does not create an attorney-client relationship between any reader and the Firm.
January 4, 2018