Choice-of-Entity Decisions Under the New Tax Act

Abstract

This short article illustrates how the 2017 Tax Cuts and Jobs Act taxes $500,000 of ordinary income depending upon whether it is earned by a corporation, a passthrough as qualified business income (QBI), or a passthrough as income from a specified service trade or business (SSTB). The article shows that the effective tax rate on QBI, which qualifies for the 20% QBI deduction, will rival the effective tax rate on income earned and distributed by a corporation. Tax on income from an SSBT will be higher than the same income from a QBI, but, if the owner of the SSBT plans to withdraw most of the earnings from the SSTB, a passthrough entity will often provide a lower effective tax rate than a corporation. The choice between passthrough entity and corporation will be affected by the amount of income that the owner withdraws from the business and the amount of income the business generates. Lower-income SSTBs may qualify for the QBI deduction, reducing the effective tax rate on passthrough income, and enhancing the attractiveness of the passthrough entity. Conversely, the effective tax rate on passthrough income increases as business income moves into the millions of dollars, triggering the application of the highest marginal rates. The choice-of-entity preference for businesses with that level of income may move toward corporations, especially if the owners do not withdraw all of the business’s income.

Keywords: Qualified Business Income, Specified Service Trade or Business, Choice of Entity, Corporate Tax Rate