The Tax Cuts and Jobs Act (the Act) has presented many significant and favorable federal tax changes; chief among them may be the reduction in the corporate tax rate from 35% to 21%. This significant decrease has pass-through entities considering the appropriateness of potentially converting to C corporation status and, more generally, otherwise changing entity structure. As discussed later, the decision to convert from a partnership to a C corporation or, for example, to revoke an S corporation election, is not a one-size-fits-all solution and many factors should be considered. If an entity chooses to change its classification, an additional benefit is the ability to adopt new accounting methods for overall income and expense recognition, depreciation/amortization, inventory and similar timing items. This Tax Alert provides an overview of choice-of-entity considerations, as well as accounting method adoption considerations.

While the corporate tax rate has been reduced from 35% to 21%, the individual top rate has only dropped from 39.6% to 37%, which results in a significant rate differential between C corporation status and pass-through entity classification. Before the Act, taxpayers often were advised to choose pass-through entity classification to avoid double taxation at both the corporate and shareholder level. Now that the corporate rate is 21%, however, the considerations relevant to choice of entity have changed and entity status should be reconsidered in appropriate circumstances.

Further expanding the rate differential is the fact that the 37% individual rate may not be the true top rate. In addition to the individual income tax, the net investment tax under Section 1411 remains at 3.8% for passive income when the taxpayer does not materially participate in the trade or business. In an effort to mitigate the difference between the corporate and pass-through rates, however, new Section 199A allows individuals a 20% deduction for qualified business income (QBI). This pass-through deduction is limited to 50% of W-2 wages, or 25% of W-2 wages, plus 2.5% of unadjusted basis of qualified product, whichever is greater. While this deduction could seem to put the pass-through rate on par with or close to the corporate rate, determining what constitutes QBI for purposes of this deduction is not entirely clear. One of the challenges in planning pass-through conversions to corporations is determining the extent to which the 20% pass-through deduction will apply.

Assuming all of a taxpayer's business income qualifies for the pass-through deduction, the pass-through rate will still be about 29.6%, creating a rate differential of about 8.6 percentage points. This rate differential on undistributed earnings is one important factor that generally leads taxpayers to consider converting from a pass-through entity to a C corporation. Additionally, the net investment tax, as well as the new $10,000 limit on individual state and local tax deductions, will increase this rate differential. Corporate double taxation, however, remains a critical factor.

Distributions from C corporations are taxable as dividends, creating a second level of tax in addition to the 21% corporate income tax. Qualified dividends are taxed at a 23.8% rate, the 20% dividend rate plus the 3.8% net investment tax rate. A consideration in this context, therefore, becomes whether the C corporation will regularly distribute income. In general, a taxpayer would need to distribute 38.5% of pre-tax income for it to "break even" at the entity level in terms of paying its taxes and providing cash to its shareholders to pay their taxes. This is a significant increase, however, as, the "break even" point before the Act was closer to 20%.

The ability to defer distributions is a primary consideration in determining whether to change to a corporate form. If a taxpayer routinely makes annual distributions, which is typical of services businesses, a C corporation classification may not be more favorable than the current classification. Even a large rate differential could be offset by the double taxation at the shareholder level. Consolidated groups and other taxpayers with multiple entities should keep in mind, however, that they do not have to convert all entities into C corporations; instead they could leave the entities that make distributions to the owners as pass-through entities.

Only taxpayers without accumulated earnings tax and personal holding company tax would truly be able to take advantage of any rate differential. These considerations have historically been minor; in light of the Act, however, a taxpayer that retains significant earnings without investing them in its business should carefully consider the impact of these tax provisions when determining whether to convert to a C corporation.

Taxpayers must model these variables to assess whether it is truly favorable to change from a pass-through entity to a C corporation. The decision to change the tax status of an entity is generally quite complex and may be very costly to unwind. As a starting point in evaluating this decision, EY can assist in modeling the projected tax impact related to choice of entity (e.g., partnership or corporation status).

Accounting methods opportunities

Aside from the potential rate reduction, an additional benefit of converting from a partnership to a C corporation is that it is a deemed Section 351 transaction, which enables a taxpayer to adopt new accounting methods (in contrast to, for example, a situation in which existing methods of accounting continue, as is the case for a C corporation that elects S corporation status). An accounting method, which includes both the overall method (cash, accrual or hybrid) and methods of accounting for particular items (e.g., depreciation/amortization, inventory, etc.), can ordinarily only be changed through an accounting method change request (Form 3115, Application for Change in Accounting Method) filed with the IRS. Certain transactions (including Section 351 transactions), however, give a taxpayer the opportunity to adopt new methods, making it an ideal time for a taxpayer to determine whether its current methods are permissible or optimal.

Certain accounting methods have changed due to the Act, which will make assessing current methods even more important. For example, under prior law, corporations and partnerships with a corporate partner generally could only use the overall cash method of accounting if their average annual gross receipts did not exceed $5 million. Under the Act, this threshold has increased to $25 million, significantly expanding the availability of the cash method. A corresponding change was made to the inventory exception for businesses not otherwise prohibited from using the cash method. The exception allows these taxpayers to either treat their inventories as non-incidental materials and supplies or follow their book treatment of inventory if their average annual gross receipts do not exceed $25 million.

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