The new federal tax law has changed the calculus around the selection of business entities by financial advisers and their clients.
Advisers trying to determine whether it's best to be a pass-through entity or a C corporation under the new regime will find the answer likely isn't as straightforward as a simple math calculation. The considerations are complex and may go beyond near-term tax savings to longer-term questions about future business goals and decisions.
"There are new levels of convolution that provide opportunity but also confusion," said Leon LaBrecque, managing partner at LJPR Financial Advisors.
"In the past I told people to go pass-through, not C corp, for most startups," Mr. LaBrecque added. "Suddenly, that becomes less prevalent."
Roughly 92% of private businesses in the U.S. are structured as pass-through entities. Pass-throughs, such as limited liability companies, partnerships and sole proprietorships, pass their business income through to their owners' tax returns. Profits are taxed at the owner's income-tax rate.
The tax law slightly reduced marginal income-tax rates, so taxes on pass-through business income will automatically be lower for most Americans. In addition, the law grants a tax break to pass-throughs in the form of a 20% deduction on qualified business income. Some may not qualify for that deduction, though, or may get a lesser deduction, because of constraints.
Concurrently, the tax law greatly reduced the federal tax rate on corporate income — to 21% from 35%.
Despite the significant reduction in the rate for C corporations, in most cases pass-throughs will still be more efficient from a pure tax standpoint, said Tim Steffen, director of advanced planning in Robert W. Baird & Co.'s private wealth management group.
Unlike pass-throughs, C corporations have a second layer of tax, which occurs at the ownership level on the income passed to shareholders as a dividend. (Most will pay 15% or 20%, the top rate.) So the effective C corp tax rate is somewhere between 32.8% and 36.8% for most business owners, Mr. Steffen said.
That doesn't compare favorably with pass-throughs, since the tax rates for those business owners would likely fall between 22% and the top 37% rate.Nor does that comparison factor in the additional 20% deduction many pass-throughs will get.
"The gap has been narrowed some, especially for businesses that don't qualify for the 20% exclusion," Mr. Steffen said. "For those that do qualify, they still have a real advantage over C corps."
However, there are several additional factors to consider that could tilt the scales.
State taxes are one. While taxpayers used to be able to deduct all their state and local taxes, the new law caps the deduction at $10,000 for state income, sales and property taxes.
That means "many individuals will no longer receive a federal benefit for state taxes paid as a result of their allocable share of pass-through income," according to a Deloitte report about entity conversion published Thursday. However, state taxes are still fully deductible by C corps.
C corporations also may make more sense for certain kinds of wealth accumulation, Mr. LaBrecque said.
For example, what if the owner of a C corp plans to retain all earnings for future investment in the business? If 100% of the income is retained, the effective tax rate for the C corp is 21% — the second layer of tax on dividends wouldn't apply.
That rate would be 16 percentage points lower than the 37% rate paid by the wealthy owner of a pass-through business. Even if this owner were to get the 20% pass-through deduction, the individual's effective tax rate would be 29.6%, which is still 8.6 points higher than the C corp rate in the prior scenario.
Conversely, if an owner needed more cash from the business, the owner would be more likely to remain a pass-through since that cash would be double-taxed in a C corp, said Wolfe Tone, a partner in Deloitte's tax group.
Estate planning may also factor into this calculation, Mr. Tone said, noting that many estate plans require cash to be distributed out of a business to facilitate estate-planning structures like trusts.
Moreover, a C corporation may not be the best choice if the owners plan to sell the business in the foreseeable future, according to the Deloitte report. If assets are sold in a C corp, the gain is double-taxed — once at the corporate level and again when profits are distributed to shareholders. With a pass-through, though, sellers wouldn't be subject to two tax layers.
"In the old days, we tended to ask [clients], 'What happened?' Now we have to ask, 'What will or might happen?'" Mr. LaBrecque explained of the shift in planning required by the tax law. "The forward-thinking advisers will have gigantic opportunities."