Why the New Tax Law Offers a Questionable Incentive to Incorporate

This spring, both Apollo and Blackstone announced that they would be converting from publicly traded partnerships to subchapter C corporations.   In changing their legal forms of organization, they will join two other prominent private equity firms, Ares and KKR, which had earlier announced their intentions to convert from partnerships to corporations.   The conversion of leading private equity firms to corporations has been seen as the vanguard of a mass conversion of businesses from pass-through entities and partnerships to corporations in response to tax rate changes that took effect in 2018.

The late-2017 tax reform, commonly knowns at the Tax Cuts and Jobs Act (TCJA), was the most substantial and significant tax law enacted in over 30 years.  The TCJA brought down personal tax rates, but it substantially reduced the corporate tax rate.  For many years, the corporate income tax served as a backstop to the individual income tax.  Before 2018, wealthy business owners could not reduce their tax liability by shifting their businesses from pass-through entities to corporate entities.  The combined corporate tax on business income and the personal tax on dividends (when that income was distributed) was simply too high for the switch to make sense even if the personal tax was deferred many years.  The TCJA changed the calculus by lowering the corporate tax rate so that the combined corporate and personal tax rates on dividends roughly equal the personal tax rate on ordinary income.  As a result, choice-of-entity questions have once again become a hot topic among tax practitioners and taxpayers.[1]

Prominent academics and others have argued that the TCJA will lead to a cascade of wealthy taxpayers incorporating their businesses and taking income as dividends or capital gains to the detriment of federal tax collections.[2]  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 pass-throughs before passage of the TCJA.[3]  In two recent articles, I take issue with the claims that there will be mass conversions from pass-through entities to C corporations and that these conversions will have a large effect on federal tax collections.

In the first article, I take issue with the simple and intuitive argument in favor of converting.  Because the top personal tax rate on ordinary income (37 percent) roughly equals the combined corporate tax rate and personal tax rate on dividends (36.8 percent), taxpayers who intend to save some of their income for later consumption would appear to be better off organizing their businesses as corporations rather than as pass-through entities.  Such taxpayers can use their newly incorporated businesses to hold their investments and thus defer the personal tax on dividends.  Although deferred taxes are reduced taxes, I argue that there is generally no tax advantage from incorporating in order to defer personal tax by making portfolio investments.  The reason is that the corporate tax imposed on such income offsets the benefit of deferring the personal tax on that income.

In the second article, I assess the possibility that 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.  I examine 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 a qualified corporation’s shares.  In each case, I argue that the provision offers only modest benefits, if any, to corporations over pass-through entities, and in any event — at least for the QSBS exclusion — those benefits predated the passage of the TCJA.

In the second article, I acknowledge that incorporation can bring some tax advantages post-TCJA if the business owners intend 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 immediately.  In particular, because current law permits 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 immediately deductible earnings in the business.  Further, incorporation brings the risk that payment of deferred salary may not be tax deductible.  In addition, there is often a substantial tax cost to switching from a corporation to a pass-through, whereas there is typically no tax cost to switching in the opposite direction – from a pass-through to a corporation.  Thus, it is understandable for pass-through owners to wait and keep their options open even if there appears to be a current benefit from incorporation.

Ultimately, it is not clear that many pass-through businesses would substantially reduce their tax burdens by incorporating.  Accordingly, the sharp uptick in incorporations that some commentators are predicting seems unlikely — especially if business owners understand and consider the full range of likely current and future tax consequences.  And even if there are massive conversions, the tax savings would probably be modest.  Thus, for example, the conversion of private equity firms into corporations probably won’t reduce taxes substantially.  As for why such firms switched, a better explanation might be that the non-tax benefits – including improved access to investment capital and the possibility of inclusion in various widely followed indexes – that they expect to receive as a corporation are now available at little, if any, tax cost.


[1] See, e.g., Bradley T. Borden, Choice-of-Entity Decisions under the New Tax Act, available at https://ssrn.com/abstract=3119829; James R. Repetti, The Impact of the 2017 Act’s Tax Rate Changes on Choice of Entity, 21 Florida Tax Review 687 (2018); Calvin H. Johnson, Choice of Entity by Reason of Tax Rates, Tax notes, March 19, 2018, Daniel Halperin, Choice of Entity—A Conceptual Approach, Tax Notes, June 11, 2018; Erin Henry et al., Tax Policy and Organizational Form:  Assessing the Effects of the Tax Cuts and Jobs Act of 2017, 71 National Tax Journal 635 (2018).

[2] David Kamin et al., The Games they Will Play:  Tax Games, Roadblocks, and Glitches under the 2017 Tax Legislation, 103 Minnesota Law Review 1439 (2019).

[3] Penn Wharton Budget Model, Projecting the Mass Conversion from pass-through Entities to C-Corporations (June 12, 2018), available at https://budgetmodel.wharton.upenn.edu/issues/2018/6/12/projecting-the-mass-conversion-from-pass-through-entities-to-c-corporations.

This post comes to us from Professor Michael Knoll at the University of Pennsylvania Law School and the University of Pennsylvania Wharton School. It is based on his recent articles, “The TCJA and the Questionable Incentive to Incorporate,” available here and, “The TCJA and the Questionable Incentive to Incorporate, Part 2,” available here.