Since the passage of the Tax Cuts and Jobs Act (TCJA), there has been increased discussion regarding what is the most tax-efficient entity structure. This is especially the case with the professional services sector. You may be aware that TCJA provided pass-through entities such as partnerships and S corporations as well as sole proprietorships with a 20% qualified business income deduction. See Our Thoughts On article Advisors Longing Clarity on Qualified Business Income Deduction for additional details. This was done to reduce the effective income tax rate on business income outside of a C corporation environment because the federal C corporation tax rate was reduced from a graduated tax rate maximum of 35% to a flat 21% rate.
Interestingly, Congress determined that this qualified business income deduction should not apply to Specified Service Trades or Businesses (SSTBs) which are defined as any trade or business that involves the performance of services in the fields of accounting, actuarial science, athletics, brokerage services, consulting, financial services, health, law, the performing arts, investing, investment management, trading or dealing in securities, partnership interests or commodities.
These law changes as a result of the TCJA have caused many business owners within the service sector to re-evaluate their legal structure for tax purposes. The quick reaction we have heard from professional service clients is the C corporation structure obviously must be the most efficient tax structure, since the federal tax rate has been reduced to 21%, and the qualified business deduction is not available to businesses that meet the SSTB definition.
There are a factors to consider before you can determine that a C corporation is the most tax-efficient structure post-TCJA. Those considerations include state corporate tax rate differences compared to the applicable individual tax rates for pass-through income. Another consideration is the amount of money that would be distributed from the C Corporation as a dividend versus bonuses paid to the shareholders. C corporations have two layers of tax. The income is taxed inside the C corporation in the year it is earned, and then any amounts that are distributed to the shareholders are taxed a second time as dividend income.
A common practice in many C corporation professional service entities is to pay bonuses to the employee shareholders in an amount that would as closely as possible zero out the income inside the corporation. That way, there is only one layer of tax on the shareholder wages and no remaining cash to distribute to the shareholders in the form of a dividend.
A recent court case may cause businesses using this scenario to think twice if that practice will survive Internal Revenue Service (IRS) scrutiny. The case, Brinks Gilson & Lione a Professional Corporation v. Commissioner of Internal Revenue[i], challenged the practice of completely eliminating the corporation’s book income through the payment of bonuses to shareholders.
In this case, the taxpayer would pay bonuses to shareholder attorneys in an amount to reduce book income to zero each year. The only remaining amount of taxable income was generated by items that were treated differently for tax purposes such as nondeductible expenses. As a result of concessions by the taxpayer in the course of the IRS examination, bonuses in the amount of $1,627,000 and $1,859,000 were characterized as nondeductible dividend distributions for the tax years under examination. Accordingly, there was a significant amount of income that is now subject to two layers of tax resulting in an increase in the C Corporation’s taxable income as a result of the adjustment as well as nondeductible dividend income to the individual attorney shareholders. The basic premise of this case is shareholder employees should receive some return on their invested capital.
This court case should cause taxpayers to consider if the C corporation structure is as efficient as once thought or if consideration of a pass-through entity structure would be more practical. There are many items to consider, and each taxpayer’s situation should be individually evaluated to determine the best course of action. Please consult your Schneider Downs tax advisor if you would like to learn more about planning considerations on this subject.
[i] (T.C. Memo 2016-20)
