Although lawmakers attempted to level the playing field between the new 21-percent tax rate for incorporated shooting sports businesses and the tax bills of owners of pass-through businesses, confusion is the name of the game. Despite a 20-percent deduction from income passed through from entities such as S-corporations and partnerships, owners of businesses operating a pass-through entity find themselves facing higher tax bills than an incorporated business.

Pass-through owners could, in fact, face personal tax rates as high as 29.6-percent — far above the 21-percent corporate tax rate created as part of the 2017 Tax Cuts and Jobs Act (TCJA). Does it make sense for an S-corporation or other pass-through entity to convert to a regular “C” corporation?

Pass-Throughs

An incorporated business electing to operate as an S-corporation or a firearms retailer choosing another form of pass-through entity, has pass-through income taxed only once, on the owner’s personal tax bill. By electing to operate as a pass-through entity, owners also benefit from the legal advantages of a corporate structure as well as the tax advantages available to a sole proprietorship.

The most attractive feature of pass-through businesses was, obviously, the tax savings for both the shooting sports equipment business and its owners. Unlike the “members” of an LLC who are subject to employment tax on the entire net income of the business, only the wages of S-corporation shareholder/employees are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which was taxed at a lower rate, if at all.

An S-corporation designation allows a business to have an independent life, separate from its shareholders. If a shareholder leaves the business or sells his or her shares, the S-corporation continues doing business relatively undisturbed. Similar rules also apply to partnerships. Maintaining the business as a distinct, separate entity defines clear lines between the shareholders and the business that improve liability protection for the shareholders.

Regular Corporations 

As mentioned, the tax rate for a regular, incorporated business has been lowered to 21 percent. An unintended consequence of the lowered tax rate for regular corporations means a majority of businesses currently operating as pass-through business entities will pay more in taxes by remaining as a pass-through than they would by revoking the S-corporation election or switching from pass-through to regular corporate form.

An important factor in the pass-through entity/regular corporate form debate has long been fringe benefits.A more than two-percent shareholder in an S-corporation cannot participate in the operation’s fringe benefits. Health insurance, for example, is not deductible with an S-corporation, but it is to a regular “C” corporation.

Of course, a firearms retailer or other business owner doesn’t have to spend a lot of money on health insurance. There are always Health Reimbursement Accounts (HRAs), allowing unlimited contributions that, if unused, can be rolled over to the next year. It’s a similar story with other fringe benefits with work-arounds available. So, why does the TCJA seemingly encourage switching entities?

TCJA Pass-Through Businesses

Under the TCJA, eligible taxpayers may be entitled to a deduction of up to 20 percent of so-called “qualified business income” (QBI) from a domestic business operated as a sole proprietorship or through a partnership, S-corporation, trust or estate. For those with pass-through income above the threshold, the deduction is allowed for up to 20 percent — but only for “business profits.” For pass-through owners with income that exceeds $315,000 for a married couple filing jointly, or $157,500 for all others, taxable income is the amount of W-2 wages paid by the business.  

All pass-through business owners under the income thresholds, regardless of whether they’re “service” professionals or not, can take advantage of the 20 percent deduction, the TCJA places limits on who can qualify, with strong safeguards to ensure that so-called “wage income” does not receive the lower marginal tax rates for business income.  

In other words, that 20 percent deduction from pass-through income applies only to business income that has been reduced by the amount of “reasonable compensation” paid the owner. That so-called “reasonable” compensation has not been defined by our lawmakers as yet.

On the downside, retailers operating as pass-through shooting sports equipment businesses lose things such as fringe benefits, plus being required to pay themselves “reasonable” compensation and deal with the other restrictions. And, then, there is the elimination of a number of itemized, personal deductions.

No longer can the vast majority of pass-through business owners deduct state and local income taxes and are permitted to write off only $10,000 of their property taxes. A regular “C” corporation faces no similar deduction restrictions.

When To Opt Out 

A shooting sports equipment operation can, of course, choose to revoke its so-called “Subchapter S” election by March 15 to have it apply for the whole calendar year. If the owner decides mid-year it is no longer advantageous to be a S-corporation, the election can be made at that point and become effective from that point on. A firearms or equipment business owner or owners choosing to terminate their operation’s S-corporation status can’t, of course, reapply for S-corporation status for five years.

Naturally, the question of whether to switch entities can be especially difficult for closely-held and family businesses that are often structured as pass-throughs. In the eyes of many experts, however, there is no longer a reason to operate a business as an S-corporation or other pass-through entity. 

Switching To Corporate Form 

Pass-through owners considering moving to a corporate entity should be aware of the dreaded “accumulated earnings tax,” a 20-percent tax on businesses holding onto too much cash and the personal holding company tax, another 20-percent penalty on undistributed passive income earned by a closely-held, regular incorporated business.

An S-corporations that was once an incorporated shooting sports equipment business converting back may be subject to a built-in gains tax — a corporate level tax on gain from certain property sales made after a corporation elects to become an S-corporation. 

There is also the matter of how much of the firearms or equipment operation’s earnings will be distributed to shareholders. While corporations will pay a 21-percent income tax rate, pass-through business owners will, as mentioned, pay as much as 29.6 percent depending on their tax bracket and the type of income.

Corporate distributions will also be taxed. Thus, if a “C” corporation’s profits are going to be distributed as dividends, the tax rate will likely be higher as a pass-through. Naturally, the distribution policies can vary widely, especially among family businesses, requiring consideration of whether there are family members who are accustomed to getting distributions every year or if there are trusts that have distribution requirements.

And, don’t forget, regular “C” corporations are still subject to double taxation. First, the corporation pays the corporate rate on its earnings, then the shareholders are taxed on dividends. An S-corporation does not usually pay corporate taxes since all income and losses are passed through to shareholders on their personal tax returns.

Decisions, Decisions

Determining who is in and who is out under the new pass-through deduction is difficult. As one example, guidance is needed to define specific “service” trades or businesses because, under the new law, a service business isn’t eligible for the tax break.  

Lawmakers plucked the definition from elsewhere in the existing rules which considers service business to be “those where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” Unfortunately, when naming those that don’t qualify, only some were actually identified.

Coming Soon, Hopefully

Not only will the decision to change the shooting sports equipment business’ entity have an impact on how much is paid in taxes, it will affect the amount of paperwork required, the personal liability faced by the owners and, especially important in today’s economy, the operation’s ability to raise money.

The TCJA has had a significant impact on the choice of entity for many firearms retailers. With the 21-percent corporate rate, many owners are considering restructuring away pass-through entities to regular corporations. The pass-through income deduction is a large consideration in whether to restructure or not, but its limited effective period raises questions about cost-effectiveness where the benefit will sunset in eight years.

Since there is no certainty that the lower corporate tax rate will remain, shooting sports equipment retailers should not overlook the possibility of additional taxes when considering conversion from S-corporation to regular corporate status. They should also review and consider other potential advantages and disadvantages of S-corporations and other pass-through entities as well corporate status before making any decision.

To switch or not to switch? Lots of dollars are at stake for pass-through businesses and their owners. Since every situation is different, the best approach might be to choose the entity for your tactical shooting products and accessories operation based on the current tax law. To help in this decision-making process, professional advice is strongly recommended.