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Tax Reform: Should I Convert to a C Corporation?

With the passing of the Tax Cuts and Jobs Act, a lot of questions have arisen from closely held business owners about converting their limited liability company (LLC) or S corporation (S corp) to a C corporation (C corp). Does it make sense to switch to or start a C corp? The answer is not that simple. Much depends on your business and the business model you operate under.

While the federal tax rate for C corps has dropped favorably to a flat 21%, there are still limitations to a C corp’s tax structure. C corps are subject to double tax. When a C corp issues dividends on their profits, the shareholders receiving the dividends are then taxed on their personal tax return, while the C corp receives no deductions for these payments. Whereas, if you are structured as an LLC or an S corp, you are taxed on the net taxable income that flows through to the owner’s individual tax return and you can distribute the funds out of your company, without double tax. If the goal of the business is to reinvest the earnings back into the company, C corps are a favorable option to take advantage of the lower tax rates. 

As a practical matter, for current operations, closely held C corporations do not normally pay dividends. Owners in these entities are often active in the business and draw a salary. The corporation gets a deduction for the salaries, but owners receiving the salary pay federal tax on that salary at a rate as high as 37%.

Upon exiting a closely held business, the sale of the assets of the business are, normally, the only viable option. Very few buyers will want to buy the ownership interest in a closely held business. If you decide to sell your business as a C corp, income generated from the sale of assets is taxed at the corporate level first and then taxed again when the net cash is distributed out to the shareholders to redeem their stock.  

The Qualified Business Income Deduction is a new deduction meant for S corps, LLCs, partnerships and sole proprietorships (commonly referred to as flow-through entities). The deduction is calculated at 20% of the trade/business income of these entities – leaving a top effective rate of 29.6%. There are limitations based on owner’s taxable income, W-2 salaries of the business, assets in the business and whether or not the business is a service or non-service business. This calculation is complicated and it would be best to consult a tax advisor on the potential impacts of this deduction and whether the flow-through business qualifies.

Another matter to keep in mind is state and local deductions are now limited on personal tax returns. State and local taxes are now capped at $10,000 on an individual’s tax return. Corporations do not have this limitation and are eligible to deduct state and local taxes that are assessed and paid not subject to the $10,000 limit.

Also, consider the timing issues when switching to and from a C corporation. Let’s say your business is currently structured as an S corp. You and your shareholders deem your business is better suited as a C corp and you want to convert your organization. It is fairly easy to switch to a C corp. But there is a “buyer beware” with that enterprise. You must wait five years after the switch to a C corp to switch back to an S corp. Once you switch back to an S corp, you could be subject to double taxation on built-in gains (unrealized appreciation on assets held while the entity is a C corporation) for an additional five years after the switch. At a minimum, you will need to live with the possibility of some degree of double taxation for up to ten years.

As always, it is best to starting having these conversations early with your tax advisor on business structures. 

 

Mr. Schuster is a Manager providing tax compliance services to individual filers, as well as assistance on tax returns for companies in the manufacturing and real estate industries.

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