$1.5 trillion[1].
That’s the estimated total tax reduction over a decade due to the Tax Cuts and Jobs Act (TCJA), reshaping the financial landscape for every U.S. business.
But with such significant changes comes a big question for business owners like you: How do these adjustments affect the tax liabilities of your specific business structure?
Since its enactment in 2017, the TCJA has altered the way businesses see their taxes, potentially saving billions across the board. However, not all savings are distributed equally. Depending on your business’s legal structure, you could be seeing different benefits—or facing unique challenges.
Did you know?
While C corporations received a permanent tax cut, bringing their rate down to a flat 21%, pass-through entities were handed a complex temporary deduction set to expire in 2025. This uneven application has stirred a mix of strategic shifts and critical decisions for American business owners trying to navigate the new norms.
In this blog, we’ll discuss the impacts of the TCJA on various business forms. Whether you’re considering a switch in your business structure or just aiming to better understand the financial implications of the TCJA, you’ll find the information you need to make informed decisions.
What is the Tax Cuts and Jobs Act (TCJA)?
Before we get into the implications of TCJA, let’s first understand the basics of this act.
The Tax Cuts and Jobs Act (TCJA), signed into law by President Donald Trump and taking effect on January 1, 2018, is one of the biggest changes to the U.S. tax system in decades. This law affects both individual taxpayers and businesses, with many of its changes set to expire in 2025.
For businesses, the TCJA reduced the corporate tax rate significantly to 21%, aiming to make the U.S. a more attractive place to do business. It also provided better tax benefits for businesses structured as pass-through entities, like many small businesses and sole proprietorships.
The law was passed by a close vote, reflecting strong political opinions. It got through the Senate with a 51 to 49 vote and the House with a 224 to 201 vote, with no support from House Democrats and some opposition from Republicans in high-tax states like California, New York, and New Jersey.
One of the key aspects of the TCJA is that while it permanently cuts corporate tax rates, it only temporarily reduces individual tax rates—these cuts will end after 2025. This temporary nature raises questions about its long-term impact on different income groups. The biggest immediate benefits go to wealthier individuals, and there are concerns that lower-income earners might end up paying more in taxes once the individual cuts expire.
Additionally, the TCJA removed the requirement that all Americans have health insurance, a major part of the Affordable Care Act. This change has significant implications for the healthcare system beyond just tax issues.
As the 2025 expiration date for many of the TCJA’s provisions approaches, understanding these changes remains essential for everyone, especially business owners planning for the future.
Understanding the impact of TCJA on different business forms
The Tax Cuts and Jobs Act (TCJA) brought significant changes to how business income is taxed in the U.S., but not all businesses were affected equally.
C Corporations vs. pass-through businesses
In the U.S., business income can fall under two main tax systems: one for C Corporations and another for pass-through entities.
C corporations are taxed twice: once at the corporate level at a flat rate of 21%, and again at the shareholder level when profits are distributed, with rates going up to 23.8% for long-term capital gains. This dual taxation system shapes many of the decisions C corporations make regarding profit distribution and investment.
On the other hand, pass-through businesses such as partnerships, sole proprietorships, and S corporations enjoy a different setup. These businesses don’t pay corporate taxes. Instead, their income is “passed through” directly to the owners’ individual tax returns, where it can be taxed at rates as high as 37%. This structure is often appealing because it avoids the double taxation faced by C corporations.
Given these distinctions, the TCJA’s reduction in corporate tax rates made C corporations more attractive in some cases by lowering the total tax burden on their income.
However, pass-through entities also saw some benefits, albeit differently, influenced by the individual tax rate changes and new deductions introduced for qualifying pass-through income.
To really understand how businesses have responded to these changes, we look to the latest IRS data in the next sections. It shows a clear shift in how businesses choose their legal structures, weighing the tax benefits against other strategic considerations unique to each business form.
As we navigate the complexities of these tax structures, it’s crucial for business owners to consider not just the tax implications but also how these choices align with their broader business goals and operational needs. As the TCJA provisions are set to expire soon, staying informed and ready to adapt is more important than ever.
The rise of pass-through businesses in the US
Long before the Tax Cuts and Jobs Act (TCJA) made its mark, the landscape of American business was already undergoing a significant transformation. Starting in the early 1980s, there was a marked shift toward pass-through entities[2]—a trend that has only grown stronger over the decades.
What caused the shift towards pass-throughs?
In 1980, pass-through businesses made up 83.4% of all business returns. By 2016, this number had increased dramatically to 96.2%. This growth is even more remarkable, considering that the total number of business entities in the U.S. tripled from about 13 million to 39 million during the same period.
Despite this explosion in numbers, the count of C corporations actually fell from around 2.2 million to 1.6 million.
Pass-through entities not only dominate in terms of sheer numbers but also in economic impact. By 2016, these businesses accounted for two-thirds of all net business income, up from just over a quarter in 1980. This growth underscores the increasing importance of pass-through structures in the American economy.
Among the various types of pass-through entities, sole proprietorships have remained the most in numbers, consistently representing between 68.6% and 71.9% of all business returns. However, S corporations have shown the most dramatic growth. From just 4.2% of entities in 1980, they grew to represent 13.0% by 2016. Partnerships have also held a steady share, fluctuating slightly but maintaining a significant presence.
This shift towards pass-through entities can largely be attributed to changes in tax regulations that made them more attractive. Major tax reforms in 1981 and 1986 significantly lowered the top individual income tax rates from 70% in 1980 to 28% in 1988. Meanwhile, the top corporate tax rate was reduced from 46% to 34%.
These changes improved the relative tax efficiency of pass-throughs compared to C corporations, fueling their growth.
What does this shift represent?
This long-term shift provides a crucial backdrop for understanding how recent changes under the TCJA might further influence the choice of business structure. As we continue to explore the impact of tax policies on business dynamics, it’s clear that the history of tax reform plays a fundamental role in shaping business decisions today.
This historical perspective is vital for any business owner considering the best structure for their enterprise as we approach the expiration of some key provisions of the TCJA.
How did TCJA impact C Corps and pass-through entities?
The Tax Cuts and Jobs Act (TCJA) brought about pivotal changes in the way both C corporations and pass-through entities are taxed, altering the landscape of American business taxation.
C Corporations
For C corporations, one of the most significant changes was the reduction of the corporate income tax rate from a top rate of 35% to a flat rate of 21%. This change was made permanent, providing a long-term tax relief aimed at boosting investment, competitiveness, and growth among these entities.
Pass-through businesses
Pass-through entities, which include businesses like S corporations, partnerships, and sole proprietorships, also saw substantial changes. The TCJA not only lowered individual income tax rates but also introduced the Section 199A pass-through deduction[3].
This allows pass-through owners to deduct up to 20% of their qualifying business income, effectively reducing their taxable income.
However, this deduction comes with its complexities. It includes limitations that relate to the amount of wages paid by the business and the business’s capital investments, particularly impacting high-income earners. Despite these limits, the deduction significantly lowers the effective tax rate on pass-through business income, maintaining what many see as a favorable tax treatment for these entities.
Does it level the playing field?
The introduction of Section 199A was primarily to create what proponents describe as “parity” between the tax treatments of pass-through businesses and C corporations. While it aims to level the playing field, recent analyses suggest that this measure continues to favor pass-throughs[4], extending a pre-TCJA preference that has long been part of the tax code.
What about other business types?
In addition to these specific changes, the TCJA also revised several business deductions applicable to both C corporations and pass-through entities.
These revisions include new caps on deductions for net interest paid, modifications to net operating loss (NOL) deductions[5]including a new cap on pass-through losses—and new rules requiring the amortization of research and development (R&D) expenses over five or fifteen years.
Furthermore, the act temporarily allows full expensing of short-lived assets, providing immediate deductions for certain types of investments.
These comprehensive changes underscore the TCJA’s broad impact on different business forms, encouraging all business owners to reassess their tax strategies and structures in light of these new rules. As we move closer to the expiration of some of these provisions, understanding these changes and their implications is crucial for strategic planning and compliance.
Latest IRS reveals on business structural changes post-TCJA
Even after the implementation of the Tax Cuts and Jobs Act (TCJA), the shift towards pass-through businesses and the decline of C corporations has persisted, as the latest IRS data indicates.
Continued decline of C Corporations
Since the TCJA’s enactment, the number of C corporation tax returns has further decreased, dropping from 1.6 million in 2016 to 1.5 million in 2020. Correspondingly, their share of business tax returns has also decreased, from 4.4% in 2016 to just 3.8% in 2020. This trend highlights the ongoing shift in business structure preferences, possibly influenced by the new tax landscape.
Stability and growth in pass-through entities
Within the pass-through sector, the data from 2014 to 2020 shows that partnerships and S corporations have maintained a relatively stable presence, accounting for about 10.6% and 12.8% of all business entities, respectively.
The most significant growth, however, has been seen in the number of sole proprietorships, which rose from 71.9% of pass-through entities in 2014 to 72.5% in 2020. This increase underscores the growing preference for simpler, more direct business structures that benefit from the TCJA’s tax advantages for pass-through entities.
Financial patterns of C Corporations
The financial performance of C corporations during this period exhibits some volatility. There was a notable drop in net income in 2017 followed by a significant recovery in 2018. This fluctuation is likely more reflective of strategic financial management—specifically, timing income and deductions to maximize benefits from the TCJA’s substantial rate cut—rather than an indicator of real changes in business operations.
Business receipts and deductions
Analysis of business receipts, which represent the gross revenues before deductions, shows a consistent pattern for C corporations before and after the tax changes, suggesting that the core business activities remained stable. However, the strategic shift in deductions to leverage the lower tax rates indicates savvy financial planning by C corporations to capitalize on the new tax environment.
Implications for business strategy
The ongoing trend towards pass-through entities and strategic tax planning by C corporations underscores the significant influence of the TCJA on business decisions.
For business owners and investors, this data is not just a reflection of past trends but a guide to future strategies, emphasizing the importance of understanding tax implications in business structuring and financial planning.
As the landscape continues to evolve with potential legislative changes, staying informed and adaptable will be key to navigating the complexities of corporate taxation and maximizing potential benefits.
What lessons do we learn post-TCJA?
Even after the Tax Cuts and Jobs Act (TCJA), the landscape of business taxation reveals that while more entities are filing as pass-throughs, the distribution of profits and business receipts between C corporations and pass-through entities has remained relatively consistent.
This scenario offers several key insights and lessons for businesses navigating the evolving tax environment in America.
The stability in business structures
A few factors contribute to the ongoing trends observed:
- Short-term data limitations: The data available through 2020 offers only a snapshot of the TCJA’s effects. A longer-term view, with more years of data, would provide a clearer picture of the sustained impacts of the tax reforms.
- Complexity of Section 199A: The Section 199A deduction, while beneficial, is complex and temporary. Its challenging nature means that its full utilization and impact on business decisions may shift as more businesses learn to navigate its intricacies.
- Transitional costs and adjustments: Switching business forms involves significant transitional costs and complexities. The full adjustment process may take several years to unfold, suggesting that the current data may not yet reflect the final outcomes of these changes.
- Preservation of pass-through benefits: despite some predictions to the contrary, the TCJA did not lead to a significant shift towards the c corporation form. instead, it largely maintained the tax advantages for pass-through entities, as evidenced by the continuing decline in both the number and share of c corporation filings.
Strategic implications for business decision-making
The ongoing preference for pass-through entities, despite the significant tax cuts for C corporations, underscores a critical lesson: tax considerations, while important, should not be the sole factor driving the choice of business form.
The current dual tax system, with its complexities and disparities, presents challenges in achieving parity between different business types.
Looking toward future reforms
As lawmakers consider the future of the TCJA provisions and their impending expirations, there is a strong case for more fundamental reforms.
Potential moves could include transitioning to a distributed profits tax system, which could simplify and unify the tax treatment of all business types. In the absence of such fundamental changes, efforts should focus on making the tax code simpler, more neutral, and more certain.
The lessons learned from the TCJA provide valuable insights for businesses planning their strategies and for policymakers aiming to create a more equitable and efficient tax system. As the debate on tax reforms continues, the goal should be to craft policies that not only address current inequities but also promote long-term stability and growth for all types of businesses.
The bottom line
The Tax Cuts and Jobs Act (TCJA) has significantly changed how businesses handle their tax obligations, depending on their legal structure. Whether you’re dealing with the complexities of a C Corporation or a pass-through entity, understanding these changes is crucial to your business’s success. However, keeping up with the USA’s evolving tax laws can be overwhelming for any small business owner, especially with key provisions set to expire in 2025.
CoCountant’s accounting and bookkeeping services make it easy for your business to stay compliant with the ever-changing tax regulations. From managing your day-to-day financial transactions and reconciliations to providing clear monthly reports and insight into the most advantageous business structure to ensure compliance with tax laws like the TCJA, we ensure your small business stays compliant.
Additionally, with our tax advisory and filing services, you can maximize crucial deductions and avoid pitfalls from shifting regulations.
With our expertise, you can confidently tackle the challenges of the TCJA, staying protected and making the most of every available tax advantage.
FAQs
When does the TCJA expire?
The provisions of the Tax Cuts and Jobs Act related to individual tax rates and a range of deductions are set to expire at the end of 2025.
When does the TCJA sunset?
The sunset provisions of the TCJA are set to take effect at the end of 2025. The outcomes of the national elections in November 2024 will play a crucial role in determining whether the TCJA is extended, modified, or allowed to expire as initially planned. The newly elected Congress and administration will have significant influence over the future of these tax provisions.
Will the TCJA be extended?
As of now, it’s uncertain whether the provisions of the TCJA will be extended. This depends on future legislative actions, which can be influenced by various political and economic factors.
Does the Tax Cuts and Jobs Act work?
The effectiveness of the Tax Cuts and Jobs Act can be seen in various ways. It successfully lowered tax rates for many individuals and corporations in the short term and simplified some aspects of the tax code. However, assessments of its long-term impacts on economic growth and income inequality vary among experts.
What did the Tax Cuts and Jobs Act do?
The Tax Cuts and Jobs Act significantly overhauled the U.S. tax code. Key changes included reducing the corporate tax rate from 35% to 21%, introducing a new pass-through deduction for sole proprietors and other pass-through entities, modifying deductions and exemptions for individual taxpayers, and simplifying tax filing requirements for many people.
When did the tax code last change before the TCJA?
Before the Tax Cuts and Jobs Act, the last major tax reform was enacted in 1986.
How did the TCJA affect carried interest?
The TCJA did not eliminate the carried interest loophole. Managers of hedge funds and similar investment vehicles continue to charge a 20% fee on profits exceeding certain benchmarks, typically around 8%. These fees are considered capital gains if the assets are held long enough, taxed at a top rate of 20% instead of the higher 39.6% for ordinary income.
What were the economic effects of the Tax Cuts and Jobs Act?
Most analysts predicted that the Tax Cuts and Jobs Act would modestly boost economic output in the short term, a view supported by early data. The long-term effects, however, remain unclear, largely obscured by the significant economic disruptions caused by the COVID-19 pandemic. Before the pandemic, there was limited evidence that the Act significantly boosted investment to spur longer-term economic growth.
