Pass-Through Businesses Rethinking Status in Wake of Tax Law

As business owners pore through the new tax law, many are asking themselves a fundamental question: Will changing how their company is structured cut their tax bills?

“This is one of the most pressing issues for taxpayers and business owners,” said Mark Everson, vice chairman of tax-consulting firm Alliantgroup LP. “They are looking carefully now at how they are legally organized.”

For many entrepreneurs, the big question is whether to operate as a C corporation, which pays its own taxes to the Internal Revenue Service, or as a pass-through company, which pays tax through individual rather than corporate returns. Pass-through businesses include S corporations, sole proprietorships and limited liability companies.

The clock is ticking. Many business owners have until March 15 to make an election that would be retroactive to the beginning of 2018.

The rethinking of corporate structures is one byproduct of the new tax bill, which cuts the corporate tax rate to 21%, down from a top rate of 35%, though owners pay a second tax on profits distributed as dividends.

“We are telling people that it makes sense to reconsider doors that have historically been closed,” said David H. Kirk, a partner with Ernst & Young LLP.

The top individual tax rate has been lowered to 37% from 39.6%, and owner of many pass-through business can deduct 20% of pass-through income, reducing the top effective rate to 29.6%, though not all qualify for that deduction.

Pride Resource Partners, a two-year-old project management consulting firm based in San Diego, soon will operate as a C corporation instead of a limited liability company. “If we incorporate, our tax burden is only 21%,” said Chief Executive Joe Maak, whose 30-person firm oversees projects for utilities. “We are going to do it very quickly.”

Brian Reardon, president of the S Corporation Association, which lobbied for favorable tax treatment for pass-throughs, said: “Every member we have is right now working the numbers.”

Some individuals also are looking at whether they should set up a new business entity for tax reasons.

Business owners filed 35.3 million pass-through returns in 2015, according to the Joint Committee on Taxation. Another 1.6 million returns were filed by C corporations. Pass-through companies have become more common since Congress lowered individual tax rates in 1986.

The moves are going in both directions and the calculations are complicated and company-specific. Cindy and Peter Kahl switched Speisekammer in Alameda, Calif. to an S corporation in January to take advantage of the new pass-through deduction. The Kahls, who have 40 employees, opted for C corporation status when they opened the German restaurant 15 years ago, figuring they might sell stock and expand.

But with those plans now on hold, the Kahls want to avoid paying a second tax on profits distributed as dividends.

“We will save a lot of money because of the double taxation,” said Ms. Kahl. “It just simplifies things.”

Mr. Maak of Pride Resource Partners said he is making the shift because his company won’t qualify for the 20% pass-through deduction due to limits on service businesses. In addition, he would be limited to a $10,000 deduction for state and local taxes, while as a C corporation, the company will be able to deduct all its California taxes.

Many companies are taking longer to decide because the calculations are complicated, said Milwaukee tax attorney Thomas Nichols, with the answers turning on the size of dividend payouts, when the owners expect to sell, expectations for what Congress might do down the road, and other factors. Pass-throughs, for instance, are likely to be more attractive to business owners who expect to sell soon because gains from the sale of a C corporation may be subject to tax at both the corporate and individual level.

Brian Durst, chief executive of natural foods company Tribe 9 Foods LLC, thinks a shift to C corporation status could be a plus. “We will be investing a lot of our profits back into the business both in terms of capital projects and key talent and marketing initiatives,” said Mr. Durst, whose company makes fresh pasta, nut butters and grain-free cookies and bars.

Another issue is you can pretty easily switch to a C corporation, but switching back is harder. Businesses switching from an S corporation to a C corporation must wait until the fifth year to elect to become an S corporation again. For five years after the switch is made, gains tied to the C corporation’s assets are taxed twice upon sale—at the corporate and individual levels. “It’s much easier to get into a C corp than get out,” said John Rooney, a director in the Washington, D.C. national tax practice of KPMG LLP.

Tony Simmons, president of family-owned McIlhenny Company, which has made Tabasco brand hot sauce for 150 years, said he considered converting to C corporation status. But it turned out, he said, that the family’s total tax bill would rise by 10% compared with what it had been paying as an S corporation under the old law because of the additional tax owners of C corporations pay on profits distributed as dividends. Instead, by staying an S corporation, the family’s tax bill will fall by roughly 6% due to the new pass-through deduction.