Should an S corp switch to a C corp? Careful consideration needed.
Reduced corporate tax rate creates a dilemma for some business owners
The recently enacted tax law, known as the Tax Cuts and Jobs Act (TCJA), dramatically lowered the effective income tax rates for most businesses. For businesses operating as “regular” C corporations the top tax rate has been reduced from 35% to 21%. Also, for “pass through” entities, such as S corporations or Limited Liability Companies (LLCs), the combination of lower individual tax rates and the new 20% Qualified Business Income (QBI) deduction could reduce the top federal tax rate on income from those entities from 39.6% to 29.6%.
This exciting news about reduced tax rates has created a dilemma for some businesses currently taxed as pass through entities. Since the reduced potential net effective pass through income tax rate of 29.6% is greater than the flat 21% regular corporation tax rate, it appears that switching to C corporation status may be beneficial.
What to consider before making a switch
Possible reasons to switch to C corporation status:
- Potentially lower overall federal income tax rates
As explained above, the 21% flat C corporation rate is lower than potential net reduced pass through rate of 29.6%. For some businesses, like professional service providers such as doctors, attorneys and accountants, the 20% QBI deduction is limited if taxable income exceeds thresholds of $315,000 for married filing joint returns and $157,500 for other filers. In those cases the pass through income tax rate could be as high as 37%.
Also, under TCJA the corporate rate reduction is supposedly permanent but the individual tax rate reductions and the QBI deduction all expire December 31, 2025.
However, see below for potential C corporation double taxation as a possible reason not to switch.
- More flexible fringe benefit rules for C corporations
Some tax favored fringe benefits, such as employer provided health insurance and cafeteria plan benefits, are limited for a more than 2% owner of a pass through entity. Regular C corporations do not have these limitations.
- Special gain exclusion rules for some C corporations
Since 1993 there has been a special benefit for owners of small C corporations to exclude most if not all of the gain from the sale of the stock of those corporations. This was rarely considered before due to the high C corporation tax rates. It may be more relevant now.
- Higher thresholds for the use of the cash method of accounting
Under TCJA C corporation businesses with average gross receipts under $25 million can use the cash method of accounting. This higher threshold may encourage more businesses to stay or become C corporations
- Effect of changes to deductions – state & local taxes and entertainment
Under TCJA the deduction for individual state and local income taxes is severely limited. These would be fully deductible by a C corporation.
In addition, beginning for amounts paid or incurred after December 31, 2017 entertainment expenses are no longer deductible. Would a business with considerable entertainment expenses rather lose the deduction at 21% or 29.6% or even 37%?
Considerations for NOT switching to C corporation status
- Double taxation of C corporations
Under current federal tax law net taxable income of a C corporation is generally subject to two levels of tax, once at the corporate tax rate, currently 21%, and then again upon distribution to shareholders, generally at the 20% capital gain or dividend rate plus the 3.8% net investment income tax under the existing Affordable Care Act.
Therefore, the potential actual combined federal tax on C corporation earnings could be as high as 39.8%, which is higher than the highest potential single level pass through rate of 37%.
- State income tax considerations
Most states conform to the federal tax status of businesses and the corporate tax rates may be higher than the individual tax rates applicable to pass through entities.
In Pennsylvania the corporate income tax rate of 9.99% is significantly higher than the personal income tax rate of 3.07%. This rate difference will likely discourage PA pass through entities from switching to C corporation status.
- Impermanence of “permanent” tax law changes
Although the federal corporate tax rate reduction to 21% is currently considered to be permanent, based on prior history the only permanent aspect of tax law is change. It is not unlikely that a different administration or Congress may increase the corporate tax rate in the future.
Process for becoming or switching to C corporation status
Straightforward for new business entities
A newly formed business can easily become a C corporation for income tax purposes. New entities established as corporations are treated as C corporations by default and entities formed as LLCs can file an election to be treated as a C corporation for income tax purposes.
Action required to revoke current S corporation status and 5 year wait to re-elect
Existing S corporations can terminate their S corporation status by revoking their S corporation election. The revocation is accomplished by submitting to the IRS written consent to the revocation by more than 50% of the shareholders. It is important to note that the S election revocation is for income tax purposes only and does not affect the legal status of the corporations. Also, once an S election is revoked the business must typically wait 5 years to re-elect S corporation status.
Favorable conversion rules under TCJA
The new law includes a few provisions that reduce some burdens of converting from an S corporation to a C corporation and seem to encourage the conversion
- Favorable ordering of distributions for S corporations with old former C corporation earnings
Under prior law, if an S corporation that was previously a profitable C corporation revoked its S election and made distributions to owners the distribution was first considered to be from the former C corporation earnings and then taxable as a dividend. The new rule allows for a pro-rata allocation of the distribution between the accumulated S corporation earnings, which would not be taxed as a dividend, and the former C corporation earnings.
- Longer spread of income from required accounting method changes
The new law provides that if a business entity is required to change accounting methods for tax purposes as a result of converting to C corporation status – for example the change to the accrual method if not eligible to use the cash method – the resulting income recognition amount can be spread over six tax years rather than four tax years under prior law.
What should you do?
As you can see, the decision to convert from an S corporation to a C corporation requires careful consideration and will likely involve extensive calculations and projections. Each business is unique and will have its own extenuating circumstances to deal with when considering such a change. Unfortunately, there is no easy answer to the question of whether or not a business should convert. The best advice is to talk to your tax advisors to determine which path is the best for your organization. The Tax Department here at Herbein + Company is ready to help you with any questions or concerns you may have. Please contact us for more information regarding the Tax Cuts and Jobs Act and consideration of the conversion process.
For additional information contact Barry D. Groebel at email@example.com.