Tax Reform Blog: Simple but Dramatic Tax Cut for C Corporations

BOSTON — The Tax Cuts and Jobs Act of 2017 may consist of more than 1,000 pages of statutory text and committee explanation, but the top headline is simple: “21% Corporate Tax Rate.”

More specifically, the graduated tax rates for C corporations that maxed out at 35% have been replaced with a 21% flat rate. Though broadly applying to all worldwide income of U.S. corporations, the consensus view is this dramatic rate cut has an international audience.

Related Legislative Changes

  • Repeal of corporate AMT. There would be no point to a new, flat 21% tax if corporations were still subject to an alternative minimum tax that kept their effective tax rate higher. The corporate AMT has been repealed. (In another post, we’ll describe how the individual AMT wasn’t repealed, but will apply to far fewer taxpayers.)

  • Reduced DRD. When corporations own stock in other corporations and receive dividends, the double-tax on corporate earnings distributed to shareholders can become a triple-tax, quadruple-tax, etc. To dampen this effect, corporations are entitled to a “dividends received deduction” (DRD) permitting them to exclude from income all or a portion of such dividends. The percentage of exclusion depends on the upper-tier corporation’s percentage of ownership of the lower-tier corporation. For dividends from ≥ 80% subsidiaries that could (or must) file a consolidated return, the DRD is and remains 100%. But as a revenue offset to the overall corporate tax cut, the DRD has otherwise been dialed back. For ≥ 20% subsidiaries, the DRD has been reduced from 80% 65%. For “portfolio investments” of corporations (< 20% ownership), the DRD has been reduced from 70% to 50%).

Some Practical Consequences

  • C corporations more attractive generally. The 21% rate obviously makes C corps more attractive as a form of business organization when compared to the top 40.8% rate that could apply to individuals earning flow-through income from S corps and partnerships. (The new top individual rate of 37% + 3.8% Medicare tax = 40.8%.) We will dive deeper into the choice-of-entity issue in a later post, but suffice to say this may change the choice-of-entity calculus for both new and existing companies.

  • Recompute the “double-tax rate.” A lot of business decisions, from choice of entity, to paying compensation vs. paying dividends, to preferred M&A transaction structure, require a rough application of the corporate double-tax rate, e., the aggregate taxes on $1 earned by a C corporation, which then distributes the after-tax earnings to shareholders. The double-tax has long been over 50%, and maybe over 60% counting state taxes. Now, once a C corp pays 21% corp tax and distributes the after-tax balance to an individual shareholder who is taxed at 23.8%, the maximum federal double-tax should be 39.8%.

  • Retained earnings — incentive & limitations. Of course, the double-tax only applies if a corporation’s after-tax profits are distributed as dividends. A C corp that retains its earnings can defer almost half of that tax until some indefinite future time. There are, however, important limitations on this strategy:

Shareholders may want or need cash. Not to be underestimated.

Accumulated earnings tax. Once upon a time, before Ronald Reagan, there was an even greater disparity between the top individual and corporate tax rates than prevails today. The C corp rate was 35%, but the top individual rate was a whopping 70%. Even when the top rate was decreased to 50% in 1981, dividends were taxed at ordinary rates. The rational and widespread retention of C corp earnings led to the “accumulated earnings tax” (AET), which imposes deemed-dividend treatment where a C corp’s retained earnings exceed “the reasonable needs of the business.” (Fun fact: the AET is one of the only federal taxes that is not self-assessed; it is only payable when imposed by the IRS.) Largely irrelevant during the decades of parity between the top individual and corporate rates, the AET may now make a comeback.

Personal holding company tax. Another product of sky-high individual tax rates, the “personal holding company” regime has renewed relevance. Certain closely held C corps with high proportions of passive income face an additional 20% tax. Be careful with that ingenious plan to put retained earnings to work in passive investments.

Section 269A and service corporations. The TCJA has prompted lots of speculation and criticism in the popular and business press surrounding whether employees can and should provide services through personal C corps. Read the fine print, in this case Section 269A, which authorizes the IRS to re-allocate income between an individual and a personal service corporation formed to provide service to a single employer. In other words, the IRS can ignore the corporation and treat the employer as paying the individual corp owner directly.

Robert Murphy