Impact of Tax Reform on Choice of Entity Determinations

Impact of Tax Reform on Choice of Entity Determinations

While the individual and pass-through (e.g., partnerships and S corporation) provisions of the ‘Tax Cuts and Jobs Act’ are generally phased out in less than a decade, the tax cuts for C corporations are permanent changes to the Internal Revenue Code. The reduced tax rate of 21 percent, from 35 percent, may increase the popularity of corporations. The Act also contains a deduction of up to 20 percent of qualified business income (“QBI”) of pass-through entities, which will provide substantial benefits for taxpayers operating certain trades and businesses. These and other factors, described in part below, could make choice of entity determinations one of the most important tax decision taxpayers will ever make.

Like so many business decisions, choice of entity determinations are based heavily on the expected return on investment (“ROI”). Cash tax liabilities may impact ROI significantly, and as a result, often influence business decisions. For example, effective tax rates push companies over local, state, and national borders. The entity selection flexibility provided in the “check-the-box” regulations has largely separated taxes from other business factors in making entity determinations. Further, the Act has largely eliminated disparities in net federal income tax rates. Lowering tax rate disparities between entity-types puts pressure on every significant tax factor, which could control the ultimate decision. Some of these factors that can impact the projected long-term net effective tax rate (“ETR”) include:

  • length of the investment period and ultimate exit,
  • special allocations of income/loss amongst partners,
  • method of capitalization (i.e., debt vs. equity),
  • state and local tax,
  • international tax,
  • deductions and losses (e.g., bonus depreciation and expensing, timing generally),
  • character (e.g., capital gain, ordinary losses, or both under section 1231),
  • accounting methods,
  • investor restrictions (e.g., publicly-traded or foreign owned), and
  • compliance costs/tax complexity.

Please connect with us if you’d like to speak with an MFA Tax professional about considerations for your business’ entity determination.

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