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New article by Knoll challenges the consensus that the 2017 tax reform bill incentivizes small business to incorporate

June 17, 2019

Despite the emerging consensus among economists and commentators that the passage of the 2017 Tax Cuts and Jobs Act (“TCJA”) will lead to mass conversions of certain kinds of small businesses into corporations to take advantage of tax benefits, University of Pennsylvania Law School Professor Michael Knoll argues in a recent report that such predictions are overstated. In his two-part article “The TCJA and the Questionable Incentive to Incorporate,” published in Tax Notes, Knoll “questions the claim that there will be a mass conversion of passthrough entities into C corporations” as a result of the tax reform law, and “also questions the specific claim that C corporations will be widely used as investment vehicles to hold portfolio investments.”

Knoll is the Theodore K. Warner Professor of Law & Professor of Real Estate and Co-Director of Center for Tax Law and Policy at Penn Law. He frequently writes and comments on how income tax laws affect business and investment decisions, offering creative proposals of how those laws might be redesigned. His research includes writings on sovereign wealth funds, private equity, international tax arbitrage, and the impact of state taxes on interstate commerce.

“The TCJA’s tax rates were the result of substantial negotiation, debate, tinkering, and compromise,” writes Knoll. “The bill’s authors were determined to lower personal and corporate tax rates as much as they could within their budgetary constraints.” Among the many reforms within the TCJA, the law imposes a “relatively low corporate tax rate (21 percent) as compared with the maximum personal tax rate on ordinary income (37 percent) and the deferral of individual-level tax.”

Critics of the law argue that those tax rates will drive the wealthiest business owners to incorporate their businesses, converting them from passthrough entities, which allocate income taxes among the owners of the business rather than paying at the corporate level. Indeed, “[t]he economists at the Penn Wharton Budget Model (PWBM) predict a ‘mass conversion’ of passthrough entities into C corporations,” estimating that “’235,780 individual business owners — especially higher income business owners or service providers — will switch from owners of pass-through entities to C-corporations[,]’” resulting in an annual revenue loss of $11 billion, or roughly 17.5 percent of the ordinary business income earned through passthroughs before passage of the TCJA.

However, Knoll argues, closer analysis of the provisions of the TCJA reveals that whatever the authors’ intentions, “the top statutory individual and corporate tax rates create very close to a level playing field between passthrough and corporate entities[,]” at least for individuals in the top tax bracket who cannot take advantage of a special deduction for passthroughs that reduces the marginal tax rate by 7.4 percent. The rough equivalence between the top tax rates for passthrough and corporate entities arises because although the corporate tax rate is a flat 21 percent and the top individual ordinary income tax rate that would be paid by passthrough entity owners is 37 percent, the top long-term capital gains tax rate is 20 percent. The result is that even after being saved and invested for several years, any tax-deferred corporate income would still ultimately be “subject to a top rate of 36.8 percent (the sum of the 21 percent corporate tax rate and 15.8 percent, which is the product of the 20 percent individual tax rate and the 79 percent of pretax earnings left in the corporation after payment of the corporate tax),” Knoll explains.  Furthermore, although the individual level tax can be deferred by investing through a corporation, the benefit of such deferral is offset by imposing a second level of tax – the corporate tax –on earnings invested through the corporation. Thus, Knoll concludes, “for taxpayers in the top individual tax bracket, the total tax burden on corporate earns and passthrough earning is now almost equal” whether income is paid out as earned or retained and invested in portfolio assets.

The second part of the article assesses “the possibility that other tax provisions [beyond the basic rate structure] could still make the corporate form more tax efficient when business owners are looking to invest substantial proceeds in portfolio investments.” Knoll analyzes four provisions in turn: the lower tax rate on interest income, the Medicare tax, the step-up in basis for corporate stock held until a taxpayer’s death and then passed to heirs and beneficiaries, and the qualified small business stock (“QSBS”) exclusion, “which allows individual taxpayers to exclude from federal tax 100 percent of their gain on the sale of qualified corporation’s shares.” In each case, Knoll finds that the provision offers only modest benefits, if any, to corporations over passthrough entities, and in any event — at least for the QSBS exclusion — those benefits predated the passage of the TCJA.

Knoll notes that incorporating might bring some advantages post-TCJA if the business owners’ intent is to reinvest earnings in the business rather than in portfolio investments, but even those potential tax reductions do not make a particularly strong case for converting from a passthrough entity. In particular, because current law permits large businesses to claim a tax deduction by taking 100 percent bonus depreciation, there is at least for now no tax advantage to using a corporation to reinvest profits in the business.  Further, Knoll writes, incorporation brings the risk that payment of deferred salary may not be tax deductible while it would be for a passthrough entity and “it is more difficult and more expensive to take assets out of corporate solution than to put them into corporate solution.”  Thus, Knoll concludes that “it is understandable for passthrough owners to wait and keep their options open even if there appears to be a current benefit from incorporation.”

Ultimately, careful analysis suggests that “it is not clear that many passthrough businesses would substantially reduce their tax burdens by incorporating,” Knoll writes. “Accordingly, the sharp uptick in incorporations that some commentators are predicting seems unlikely to occur — especially if business owners understand and consider the full range of likely current and future tax consequences. And even if there are massive conversions by wealthy business owners, their tax savings would likely be modest.”