The Impact of the 2017 Act's Tax Rate Changes on Choice of Entity

Abstract

In an ideal world, the effective tax rates for C corporations and partnerships would be identical and tax rates would not play a role in selecting an entity for conducting a business. Unfortunately, the new statutory rates in the 2017 Tax Act and the 20% § 199A deduction have not leveled the playing field.

This article shows that the choice of an appropriate entity under the effective tax rates of the 2017 Tax Act is complex and is affected by whether an entity will retain and reinvest its earnings, by how long this retention will occur, by the availability of the § 199A deduction, by the applicability of the 3.8% Medicare surtax, and by the pre-tax rate of return on retained earnings. The article calculates the effective tax rates for various scenarios using these variables and shows that a partnership frequently has a lower effective tax rate than a C corporation if earnings are distributed annually.

The picture changes, however, if a C corporation will retain earnings. A C corporation that is a qualified small business (“QSB”) corporation under § 1202 will have a lower effective tax rate than a partnership if investors intend to sell their stock in lieu of having the corporation distribute its earnings. If a C corporation is not a QSB or investors do not wish to sell their stock, the C corporation will still have a lower effective tax rate if investors permit the corporation to retain earnings for sufficiently long periods. The article calculates the retention periods for various scenarios using the above variables and shows that a C corporation will have lower effective tax rates if it retains its earnings for 3.9 years to 30.1 years, depending on the circumstances. Investors may view such retention periods as too long, if they have short-term investment horizons.

The result is that the 2017 Tax Act has made it more difficult to predict which choice of entity will have the lowest effective tax rate in the long run. Tax planning has become more important, not less.

Keywords: Choice of entity, C corporation, partnership, tax rates, effective tax rates, qualified small business, 199A, 2017 Tax Act, tax policy, tax