Should I Convert My Business to a C-Corporation?
With A Flat 21% Rate, Converting A Flow Through Entity To A C Corporation Is Attractive, Or Is It?
Pass-through entities have historically provided a more tax-efficient structure than C-corporations, but is this still the case? The Tax Cuts and Jobs Act (TCJA) of 2017 reduced the corporate tax rate to a flat 21% for tax years beginning after December 31, 2017. The TCJA also repealed the corporate Alternative Minimum Tax (AMT) and changed the requirements to qualify for the cash method of accounting, allowing taxpayers with average gross receipts of $25 million (indexed for inflation) or less for the prior three taxable years to now qualify. As a result, many taxpayers are reassessing their current entity structures to determine if they should switch from being a pass-through entity to become a C-corporation. This assessment requires careful analysis, as there are many factors
that must be considered; some of these factors are not tax-related and are beyond the scope of this article.
The first, and perhaps the most attractive, factor is the difference in the marginal tax rates. Pass-through entities generally are not subject to federal income taxes. Instead, each owner of the entity pays the income tax liability on his or her allocable share of the pass-through income.
The highest marginal tax rate for individuals is 37%. When compared to the new corporate tax rate of 21%, it might be tempting to conclude that converting to a C-corporation would provide a reduction of 16 percentage points in the tax rate. That may not necessarily be the case. The TCJA enacted a provision that allows owners of qualified pass-through entities to claim a deduction equal to 20% of the entity’s taxable income. This deduction is commonly known as the Qualified Business Income, or QBI, deduction. With proper planning, an individual may be able to reduce the effective tax rate on any pass-through income to 29.6%.
Moreover, owners of pass-through entities operating in states that do not have an individual income tax should consider the state tax implications of converting the business to a C-corporation. For instance, the owners of a pass-through entity operating in Florida are not subject to state income tax. Conversely, a C-corporation is subject to a flat state tax of 5.5%. Considering that state income taxes are allowed as a deduction on the federal tax return, the C- corporation would be subject to a combined effective federal and state income tax rate of approximately 25.3%. As this example illustrates, a pass-through entity that qualifies for the QBI deduction may only reduce its effective tax rate by approximately 4.3 percentage points if it converts to C–corporation status — not 16.
Another important factor in analyzing the impact of a C-corporation conversion is the taxation of distributions. Owners of pass-through entities are taxed on their allocable share of the business income, even if the cash is not distributed. Subsequent distributions of the income, however, can be made tax-free. Yet, there may be valid business reasons for keeping the earnings in the entity. One such reason could be to provide necessary working capital for the business. Another may be to provide for contingencies such as the payment of a potential lawsuit. In a pass-through entity scenario, the taxation of the income would be accelerated and would not coincide with the timing of the cash distributions to the owners. A C-corporation may be more advantageous in this case. Assuming that the pass-through entity did not qualify for the QBI deduction, the undistributed income would be taxed at a marginal federal tax rate of up to 37%. A C- corporation in the same situation, however, would only pay a flat
tax of 21%.
Nonetheless, it is important to note that a C-corporation cannot avoid paying dividends without having a reasonable business need; otherwise, it risks becoming subject to a 20% tax known as the Accumulated Earnings Tax. The reasonableness of anticipated needs should be judged on the facts existing at the close of the year, and because the burden of proof rests with the taxpayer, it is crucial to have proper documentation.
Finally, although the TCJA significantly reduced the corporate tax rate, it did not eliminate double taxation. That is, earnings of a C- corporation are taxable to the entity at a federal rate of 21% and are also taxed to the shareholder when the dividend is paid, at a rate of up to 23.8%. Ignoring state taxes, that’s a total tax rate of 44.8%. If an owner of a profitable pass-through entity distributes the earnings every year, then the C-corporation structure may not be the most tax- efficient. Converting to a C-corporation may also be disadvantageous if the owner is contemplating an exit strategy in the near future. Assuming that the transaction were structured as an asset sale, the C-corporation would pay federal tax on the gain at a rate of 21%. The shareholder would also recognize a gain on the difference between the subsequent cash distribution and the adjusted basis of the stock. The tax rate on the gain can be as high as 23.8%.
Whether a pass-through entity should convert to become a C– corporation, given the enactment of the TCJA, depends on each taxpayer’s unique circumstances. This is a consideration that requires careful analysis and planning. In the case of an S corporation, it is particularly important to consider the long-term effects of converting because once the S election is terminated, the entity cannot reelect S status for at least five years following the revocation. Failure to diligently consider all ramifications of a conversion may result in detrimental tax consequences down the road.
For assistance in evaluating the optimal structure for your business under the new rules of the TCJA and in planning your short- and long-term tax strategies, contact your Marcum tax professional.