Tax reform pass-through impacts

Deloitte Tax perspective: Digging into the dilemma for partnerships and S corps

The 2017 Tax Act (the Act)ⁱ offers a combination of tax-rate reductions and various tax breaks for C corps and certain owners of certain pass-through entities like partnerships or S corporations (S corp). However, the lack of clarity in the new law leaves many pass-through entities struggling to understand whether they will qualify for such tax-rate reductions and if it even makes sense for them to retain pass-through status.

To convert or not to convert to a C corp is the dilemma many private companies are facing today. Arriving at the right course of action will require more than just modeling. A partnership or S corp must consider the strategy and future of their business, and the potential ripple effects of the new and interrelated provisions. Given the complexity of tax law, the devil is in the details, and business owners have a fiduciary responsibility to vet the matter thoroughly and understand the choice of entity tax considerations.

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Partnerships and S corps should look beyond the math

While the Act lowers the C corp federal tax rate to 21 percent, it also introduces advantages to certain individual and trust owners of partnerships and S corps through a special 20 percent pass-through deduction. However, many business owners will not qualify for the full deduction under tax reform for pass-throughs. In addition, a new cap on state income tax deductions at the individual level ($10,000) may cause state income taxes generated from ownership in a pass-through entity to become 37 percent more expensive because of the limited or lost deductions. These changes leave many partnerships and S corps wondering, Is now the time to convert to a C corp?

At first glance, arriving at the answer may seem easy: Use basic math to quantify the rate differential and the detrimental impact of limited state income tax deductions by individual shareholders. But there are other factors to be considered.

Moving your entity conversion decision forward

With the right approach and support, understanding tax reform for pass-throughs and analyzing your choice of entity tax considerations doesn’t have to be a painstaking process—but it should be a thorough one. It may be beneficial to go through this process up front—determine whether a conversion is right for your business and understand what it’s going to take internally to make the most of it.

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ⁱAn Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.