THE IMPACT OF THE 2017 ACT'S TAX RATE CHANGES ON CHOICE OF ENTITY.

Author:Repetti, James R.
 
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  1. INTRODUCTION II. EFFECTIVE STATUTORY TAX RATES PRIOR TO THE ION TAX ACT III. EFFECTIVE STATUTORY RATES AFTER THE ION TAX ACT A. Tax Changes in the 2017 Tax Act B. A Level Playing Field in a Narrow Unrealistic Circumstance: No Section 199A 20% Deduction, No Retention of Earnings, and No Medicare Surtax C. The Conditions for Parity Are Unrealistic Because the Medicare Surtax Applies to Dividends from the C Corporation and Passive Trade or Business Income from the Partnership D. The Conditions for Parity Are Also Unrealistic Because the 20% Deduction Under Section 199A Will Be Available in Some Situations E. The Conditions for Parity Are Also Unrealistic Because Earnings Will Often Be Retained 1. Corporate Earnings Are Retained in a Qualified Small Business Corporation and Investors Realize Corporate Profits by Selling Stock 2. Investors Realize Corporate Profits Through Dividend Distributions After Earnings Are Retained or Corporation Is Not a QSB a. Partnership Qualifies for Section 199A 20% Deduction, Earnings Are Retained, and the C Corporation Is Not a QSB b. Impact of Unavailability of the Section 199A 20% Deduction Where Earnings Are Retained IV. CONCLUSION I. INTRODUCTION

    The double tax imposed on the earnings of C corporations results in significant economic inefficiencies because of its effect on the choice of entity for conducting a business. (1) All other items being equal, the double tax distorts taxpayers' choice of entity because it motivates taxpayers to favor flow-through entities when they otherwise would not. The reduction in the corporate and individual tax rates in the legislation popularly known as the Tax Cuts and Jobs Act of 2017 (2) (the "2017 Tax Act") has been in part justified on the grounds that the rate changes would help achieve parity between effective tax rates imposed on C corporations and on flow-through entities. (3)

    This Article suggests that the 2017 Tax Act has not achieved this goal. To illustrate, this Article focuses on three changes made by the 2017 Tax Act--the reduction of the corporate tax rate to 21%, the reduction of the maximum individual tax rate to 37%, and the allowance of a 20% deduction in Code section 199A for "qualified business income." It shows that the interaction of these changes with three existing factors (a corporation's ability to retain earnings, the rate of return on those earnings, and the 3.8% Medicare surtax) have increased the complexity in selecting between a C corporation and an entity taxable as a partnership. (4) As discussed below, depending on the mix of these factors, the effective tax rate for a partnership will be less than, equal to, or greater than the effective rate for a C corporation. As a result, the 2017 Tax Act has made tax planning more important in selecting an entity to conduct a business, not less.

  2. EFFECTIVE STATUTORY TAX RATES PRIOR TO THE 2017 TAX ACT

    Prior to the 2017 Tax Act, it could be safely predicted based on the relative tax rates for C corporations and individuals that entities taxable as partnerships would have a lower effective tax rate than C corporations on their operating incomes. The effective tax rate for a C corporation and individual stockholders, assuming a maximum corporate rate of 35% on the C corporation's income and 20% on the dividend income of the individual stockholders, was 48%, (5) ignoring the Medicare surtax under Code section 1411. Including the Medicare surtax, which would apply to dividends paid by the C corporation to its stockholders who are individuals, (6) the effective rate was 50.47%. (7) In contrast, the effective tax rate on a flow-through entity, such as a partnership, was 39.6%, assuming that the partner was an individual subject to the maximum marginal tax rate and was not subject to the 3.8% Medicare surtax because her share of the partnership's income was not passive. (8) If the partnership's income was passive to an individual partner, the effective tax rate was 43.4% as a result of the application of the 3.8% Medicare surtax. In all situations, regardless of whether the Medicare surtax applied, the partnership had the more favorable effective tax rate.

    This is illustrated in Example 1.

    Example 1: Individuals A and B were considering in 2017 whether they should organize a real estate investment business as a partnership or as a C corporation. They anticipated that their real estate investments in land would generate rental income of approximately $500,000 per year, which they would share equally. A and B have significant income from other sources and their shares of the $500,000 rental income would be subject to tax in 2017 at the maximum marginal rate of 39.6%.

    First, if A and B placed their land into a partnership, the $500,000 rental income would be recognized by them, and they would pay a federal tax of $198,000 (39.6% of $500,000) in 2017. If the partnership's activity qualified as a trade or business that is not passive within the meaning of Code section 469, the 3.8% Medicare surtax would not apply. (9) Moreover, no further income tax liability would be incurred when the partnership distributed the rental income to them because their outside bases increased by their share of the partnership's income.

    In contrast, if they placed their land into a C corporation, the income would be taxable to the corporation and would be taxed again when distributed to them. This would result in a total tax of $252,350 in 2017. A tax of $175,000 would have been incurred at the corporate level (assuming a maximum corporate tax rate of 35% applied to $500,000), and an additional tax of $77,350 (10) would have been incurred when the income remaining after payment of the corporate tax was distributed to A and B as a dividend subject to the 20% dividend tax (11) and 3.8% Medicare surtax. (12) Since the effective tax rate of the partnership was 39.6%, while the effective rate for the C corporation was 50.47%, (13) all other items being equal, A and B would prefer the partnership.

    If the partnership's income were subject to the 3.8% Medicare surtax, the outcome would not change. The partnership's income would now cause A and B to incur a $217,000 tax liability (14) in 2017 for an effective tax rate of 43.4%. This would still be less than the C corporation's effective tax rate of 50.47% in 2017.

  3. EFFECTIVE STATUTORY RATES AFTER THE 20017 TAX ACT

    1. Tax Changes in the 2017 Tax Act

      The 2017 Tax Act directly changed the rates illustrated in Example 1 for taxable years beginning after December 31, 2017, by lowering the corporate rate to a flat 21%15 and reducing the maximum individual rate to 37%. (16) It also indirectly reduced the maximum rate for individuals for their "qualified business income" by allowing a new 20% deduction in section 199A. The section 199A deduction in effect reduces the maximum individual tax rate from 37% to 29.6%.

      The complexity of section 199A makes it difficult to determine when and to what extent it will apply. Section 199A allows non-corporate partners and S corporation shareholders to deduct an amount equal to 20% of the "qualified business income" generated by the flow-through entity's "qualified trade or business." Sole proprietors are also allowed to deduct 20% of the "qualified business income" generated by their "qualified trade or business." Corporations are not allowed to claim the deduction.

      The application of these terms and the calculation of the deduction occurs for each individual sole proprietor, partner, and S corporation stockholder based on his or her individual circumstances. (17) The result is that some owners of an entity may be eligible for the deduction, while others will not. For taxpayers with incomes below the "threshold amount" ($157,500 for single taxpayer, $315,000 for married taxpayers), all trades or businesses are "qualified trades or businesses." For taxpayers with taxable incomes above the threshold amount plus $50,000 ($100,000 for joint returns), a "qualified trade or business" does not include most professional services (so-called "specified service trades or businesses"), such as those provided by accountants, lawyers, financial services, and medical providers, but does include professional services provided by architects and engineers. (18) For all taxpayers, regardless of their amount of taxable income, the term qualified trade or business does not include the trade or business of being an employee. (19)

      "Qualified business income" in general means income from a qualified trade or business conducted in the United States, but does not generally include investment income. (20) The 20% deduction can, in general, be reduced or eliminated for taxpayers with taxable income in excess of the threshold amount if the trade or business does not pay certain levels of wages or utilize certain levels of depreciable tangible assets in the U.S. trade or business. (21) The greater the amount of wages paid or the amount of depreciable property held in the trade or business, the less likely the limitation will apply. In addition, the amount of each taxpayer's 20% deduction is reduced if the taxpayer has net losses from other qualified trades or businesses because the amount of the deduction is determined by combining the taxpayer's deductible amounts for all of the taxpayer's qualified trades or businesses. (22)

      The unavailability of the deduction for "specified service trades or businesses" creates uncertainty because of some broad language in Code section 1202(e)(3)(A), which section 199A incorporates by reference. Section 199A(d)(2) states that the "term 'specified service trade or business' means any trade or business--which is described in section 1202(e)(3)(A) (applied without regard to the words 'engineering, architecture')." Section 1202(e)(3)(A) in turn lists specific trades or businesses and then very broadly adds, "or any trade or business where the principal asset of such trade or business is the reputation or skill...

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