New Tax Law Creates Old Tax Problem
For years the highest corporate tax rate and individual tax rate were very close. Taxpayers wanting to accumulate wealth would usually choose a passthrough type entity in order to pay the individual rate instead of paying a double tax – the corporate rate and additional tax on a dividend paid from the corporation. However, with the changing of the corporate tax rate to 21% and the highest individual rate lowering to only 37% this could potentially change. This was one of the stated goals of the IRS as they wanted the new laws to cause taxpayers to be indifferent when choosing a business entity as far as taxes.
A simple example can illustrate the result and likely planning. Assume a taxpayer needs all of their business earnings in their pocket by year end. Ignoring self-employment tax, the choice between passthrough and corporation is not much different for federal purposes. If an LLC earns $100 an individual in the top tax bracket would pay $37 and have $63 remaining. If it was a corporation, the taxes would be $21, leaving $79 to be paid as a dividend, where taxpayer would pay the dividend tax of 20%, which results in $63 remaining as well. Obviously, there are other factors, such as the net investment tax and state taxes, but in general you can see the difference is not much. Now, consider that the 20% dividend does not have to be paid and can be deferred to the future. The accumulation of wealth at 21% in the corporation as opposed to 37% at the individual level will make for a lot of yearly tax savings, and the time value of money will greatly offset the dividend tax in the future.
Since there is once again a motivation to keep earnings in a corporation, there is a tax law resurfacing that hasn’t been given much consideration in years. This law is the accumulated earnings tax. This is a tax that applies when a corporation accumulates cash beyond bona fide business reasons without paying a dividend. There are thresholds and analysis that make this determination. If it is determined the accumulation is beyond the needs of the corporation the tax kicks in to essentially make them pay the tax on the would-be dividend. Therefore, the point is to make the corporation have no advantage in not paying dividends. This makes the planning discussed above a little more difficult and furthers the IRS’s goal of tax neutrality when choosing what type of business to use.
In addition to being something to consider when choosing a business entity, this also illustrates the importance of detailed planning when the tax laws change. Many times, the first and most obvious solutions are not always as they seem. Over the next few years as these new tax laws are implemented there are likely to be many unexpected twists and turns.