If you’re a business owner, there’s a good chance you’re still trying to decipher how tax reform impacts your business. It’s understandable, as much still needs to be clarified as the IRS implements the changes outlined in the Tax Cuts and Job Act. Plus, state and local taxes may change as governments react.
So what’s the right way to prepare? Matt Doherty, a Senior Wealth Planner on the Business Transition Planning team within Wells Fargo Private Bank, says the best approach may be to gather your advisors to talk about the big picture, and one important detail — reclassifying — that may inform it. “You should step back and consider the true impact of tax reform on your business,” he says, “over the short and long haul.”
The detail: Pros and cons of reclassifying
One aspect of tax reform in particular grabbed a lot of headlines: A new top marginal tax rate of 21 percent for C Corps, compared to the individual maximum of 37 percent. Because of this, converting your business from a pass-through entity — which includes partnerships, S Corps, LLCs, or sole proprietorships, which are all taxed at individual tax rates — to a C Corp may seem like an easy way to get that lower rate. It’s not.
First, there’s the added layer of tax on money that’s distributed. Once a pass-through business owner pays individual taxes, he or she can distribute what’s left. In a C Corp, there’s a second layer of tax on those dividends, up to 23.8 percent (inclusive of the Net Investment Income Tax of 3.8 percent).
Here’s a comparison: If an S Corp owner makes $100, $37 goes to taxes, leaving $63. If the business is classified as a C Corp, federal taxes paid would total $21. Assuming the remainder of $79 is distributed to the owner, another $18.80 (if the rate is 23.8 percent) of taxes are paid, leaving a net of $60.20 for the business owner. This would result in an overall effective tax rate on the S Corp of 37 percent vs. 39.8 percent on the C Corp, assuming a 100 percent distribution rate.
Section 199A gives pass-through entities a deduction of up to 20 percent of qualified business income.
Second is Section 199A, which gives pass-through entities a deduction of up to 20 percent of qualified business income. That has its own uncertainties but could reduce their taxes significantly. For example, if all the income of the pass-through entity qualifies, the effective top marginal rate would drop from 37 percent to 29.6 percent, which remains favorable to the 39.8 percent on the C Corp with all earnings distributed.
Finally, there’s the lingering uncertainty around the reforms. Converting to a C Corp is relatively easy, but it’s much harder to change back — including a five-year waiting period.
“If you’re thinking about reclassifying, you need to consult your close advisors, and you need to coordinate all of their analyses,” Doherty says. “You’ll want to involve your business and personal CPAs, your corporate tax counsel, and your personal wealth planner, with everyone on the same page.” These analyses, he notes, will cost money and resources, maybe as much or more than your proposed tax savings. “You’ve got to think long and hard [about] if that’s something that makes sense to undertake.”
The big picture: Questions worth asking
For Doherty, the detail of reclassifying prompts the need to get answers to bigger-picture questions that are specific to your business and your overarching plans and goals. The answers will come from experts in your company as well as from your key advisors. Among those questions:
- Will I have more after-tax cash flow? If so, how much, and for how long?
- Should I invest the money back into the business, or take some out?
- Does this change the value of my business?
- Will the changes I make help my company now? What about five years from now?
- How will changing and expiring provisions in the tax reform, like bonus depreciation, impact my business and income tax liability over time?
“Don’t rush to make decisions based on the headlines,” Doherty says. “At the end of the day, balance the risk/reward of any potentiall short-term tax savings with broader thoughts about the future of your business and your personal financial situation. Know all the answers you can before you act.”