Individual tax rates ranged from 10% to 39.6% in 2017, and while still remaining progressive in nature, the overall rates were lowered with the new Tax Cuts and Jobs Act.
By Arik Van Zandt, Business Valuator
Divorce lawyers don’t need to be tax experts, but when it comes to business valuation, understanding how corporate-level taxes are being treated in the valuation is worth knowing.
The new Tax Cuts and Jobs Act (TCJA) that was signed into law in December 2017 was highlighted by a simplification of the effective tax rate for C-corporations, with a new flat rate of 21%. Historically, C-corporations were taxed at progressive rates that ranged from 15% to 39%, depending on the level of taxable income. The income ultimately received by a shareholder in a C-corporation suffers from double taxation: first taxed at corporate rates with any subsequent distributions taxed at individual rates.
S-corporations and other “pass-through” entities are not taxed at the corporate level, but instead, the income that the business generates is passed onto the shareholders, who then pay taxes on that income at individual rates. Individual tax rates ranged from 10% to 39.6% in 2017, and while still remaining progressive in nature, the overall rates were lowered with the new tax law.
Tax Cuts and Jobs Act: Effect on C-Corporations and Pass-Through Entities
The following examples attempt to simplify the overall effect on taxable income for both C-corporations and pass-through entities. While simple in presentation, this analysis concludes that C-corporations will enjoy a greater benefit from the new tax laws than pass-through businesses.
While pass-through entities have historically been a tax-advantaged structure, after-tax distributions (as shown in Table 1, below) increased marginally, by only 2.5%, based on the new TCJA. This increase in after-tax earnings is the result of slightly lower individual tax rates.
As shown in the next example, after-tax distributions for C-corporations increased more significantly, by 20.1% on an assumed $1 million in taxable income. Previously, only approximately $660,000 would have been available for dividends based on $1 million in taxable income. Now, with the reduced and simplified corporate tax rate of 21%, $790,000 will be available for dividends to shareholders. (See Table 2)
Incentives to Convert to a C-Corporation
Given the lower C-corporation tax rates, pass-through businesses may be enticed to switch to a C-corporation and enjoy the benefits of C-corporations – such as shareholder flexibility and the ability to offer different classes of shares. The Tax Cut And Jobs Act makes it relatively easy for pass-through entities to convert to a C-corporation during the next two years. If a conversion requires a change in accounting method, which results in taxable income, that income is spread over six years. In addition, a new C-corporation that distributes previously earned income can do so indefinitely as if it were a pass-through instead of just in the year after the conversion.
TCJA’s Deduction for Qualified Business Income
To combat the examples above, the Tax Cut and Jobs Act created Section 199A. Business income that passes through to an individual from a pass-through business will be taxed at individual tax rates less a deduction of up to 20% (which is subject to limits and restrictions, of course).
The following is an overview of “Section 199A–Deduction for Qualified Business Income of Pass-Through Entities.”
Taxpayers other than C-corporations will generally be entitled to a deduction equal to the sum of:
1. The lesser of:
- a. the taxpayer’s “combined qualified business income amount”, or
- b. 20% of the excess of the taxpayer’s taxable income for the taxable year over any net capital gain plus the aggregate amount of qualified cooperative dividends, plus
2. The lesser of:
- a. 20% of the aggregate amount of the qualified cooperative dividends of the taxpayer for the taxable year, or
- b. the taxpayer’s taxable income (reduced by the net capital gain).
A taxpayer’s combined qualified business income (QBI) amount is generally equal to the sum of
- 20% of the taxpayer’s QBI with respect to each qualified trade or business, plus
- 20% of the aggregate amount of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
Not everything in the new tax code was done to simplify its application, but based on the TCJA, we expect to see many companies make the switch from a pass-through entity to a C-corporation.
Arik Van Zandt is a Managing Director with Alvarez & Marsal Valuation Services. He specializes in the valuation of business and other assets, supporting divorce counsel by providing financial analysis reports, asset tracing, and serving as an expert witness. www.alvarezandmarsal.com
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