Should I Change to C Corporation Due to New Reduced 21% Tax Rate or Continue Being S Corporation due to New 20% Tax Deduction?

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A big question raised by the recent tax reforms for most small business taxpayers is that should they operate as a C corporation due to tax rate reduction to 21 % or an S corporation that has always arguably been the preferred structure due to one level of taxation, and more so due to new tax deduction of 20% before the income is made subject to tax. The below should help to decide.

By: Baljeet Singh

Before we evaluate the impact of recent tax changes, let us understand how basic taxation works for C corporations and pass through entities (which includes limited liability companies, S corporations, partnerships and sole proprietorship). C corporations are separately taxable entities that file a corporate tax return and pay taxes at the corporate level. When the income is distributed to business owners, they pay taxes again at the individual level on the distributions being treated as dividend income. On the other hand, S corporations are pass-through tax entities. They file separate federal return, but no income tax is paid at the corporate level. The profits/losses of the business are instead “passed-through” the business and reported on the owners’ personal tax returns. Any tax due is paid at the individual level by the owners.

The recent changes in the Tax Cuts and Jobs Act specially the reduction in the corporate tax rate to 21% gives rise to a very crucial question for most of business owners – is it better to operate as a pass-through entity or a C corporation? Sadly, there is no single answer that will be applicable to all situations, and there are several factors, as discussed below, that must be taken into consideration before arriving upon a final decision.

Reduced corporate tax rate of 21%

The reduced highest corporate tax rate is 21% while highest individual tax rate is 37% for the year 2018. Apparently, this indicates that businesses operating as C corporations will experience incredible tax savings as compared to pass through entities. However, this does not reflect the true picture. When the second shareholder level tax is taken into consideration for C corporations, the overall tax rate for the income may amount to 37% or higher, which may be more than the highest individual tax rate applicable for pass through entities.

Further, the truth is that pass-through income is often subject to lesser individual rates – from 10% to 35% – depending on income levels of the stockholders. Reason for this is that only few business assign to its owners the levels of income that are taxable at 37% rate, which usually is more than 500,000 dollars.

New deduction for pass through entities

The Tax Cuts and Jobs Act launches a new deduction of up to 20 % on the business income of pass-through entities. Apparently, this new deduction greatly reduces the tax rate on the pass-through incomes, bringing it closer to or lower than the new  21 % tax rate of the C corporations. However, the following rules related to the deduction need to be reviewed closely to evaluate whether the deduction will apply or no.

The deduction is not applicable to certain businesses in the service sector particularly service providers such as accountants, doctors, lawyers, etc. that needs to be reviewed in detail before reaching any conclusion.

Further, deduction generally cannot go beyond the following figures:

  1. 50 % of wages
  2. 25 % of wages along with the 2.5% of the depreciation costs of a company’s assets used during the recovery period.

However, the above limitations as to deduction do not apply when the taxpayer has less than $315,000 dollars of the total income that is liable to taxes.

Hence, the income and nature of the business determine whether or not the 20 % deduction will apply.

Here, it is important to note that even when the businesses are unable to use the new pass-through income deductions, they will pay anywhere between 10% to highest of 37% depending on the overall income of the stockholder.

Double taxation on funds taken from C corporations

As mentioned above, the biggest and well-known issue with operating as a C corporation is the second shareholder-level taxes imposed on funds given by the corporation in the form of a dividend or on the capital gain accumulated through the sale of shares.

An important factor to consider is that the second shareholder level tax applies only when there is distribution. When the C corporation is not required to, or does not, issue its after-tax proceeds, then it can invest these net proceeds back into the business, with the income being taxed at 21%. Higher earning individuals will be charged with a 21% rate that will be lower than the ordinary income rate. However, a C corporation should also consider the tax on accumulated earnings, which is charged for retaining extra funds (more than one needs). A C corporation has the permission to accumulate around 250,000 dollars. If any amount is retained over this amount, the corporation should be able to prove that the amount has been retained to accommodate the needs of the growing business considering the nature of the business.

Taxes on sale of business

While tax rate reduction for C corporations and new tax deduction  for pass through is being given a lot of attention after the Tax Cuts and Jobs Act, consideration should be given to an important factor that is taxes on the sale of business.

Generally, business can be sold off either as a sale of equity or sale of assets. When it is a sale of equity, then it will produce capital gain taxes, and if the stock was held more than one year, the preferential tax rate, as applicable for long term capital gain, will apply. In addition to that, a part of the gain generated from the sale of stocks may not be subject to the federal income tax when certain conditions are met. Utilizing the C corporation status makes it legal to use the tax-free structure of reorganization for the sales.

On the other hand, when business sale transaction is structured as sale of assets, then gain on sale of assets will be subject to the 21% rate, and the distribution to stockholder will be subject to taxes as dividend, as referred to earlier and hence higher overall tax.

Conclusion

Since there are several factors that must be considered, it is quite clear that the new law pertaining to reduction in corporate taxes to 21% should not prompt taxpayers to operate business in one form or the other. Every business needs to have their tax advisor evaluate their specific situation and arrive at the right business structure to continue in the future.