S Or C Corp Status?

S or C Corp Status?

Tax law prompts rethinking of common wisdom

The 2017 Tax Cuts and Jobs Act (TCJA) brought lower tax rates and liabilities to many individual taxpayers and businesses. However, the law also has called into question the traditional value proposition for S corporation (S corp) status for many closely held companies. Indeed, many owners of such companies have been making the switch to C corporation (C corp) status, and many more are thinking about doing so.

The fundamental motivation is tax-based, but other considerations can also come into play. Could you beneﬁ t from converting your business to C corp status? As with any major business decision, the answer comes down to a series of “it depends” considerations, both objective and subjective. This paper presents an overview of the potential opportunity and the factors that may determine the answer in your particular situation.

Before the New Tax Law S corp status has long been attractive to many small companies due to The top C corp their being taxed only at the shareholder level, instead of both the corporate and shareholder levels. For example, pre-TCJA, the owner of a C corp in federal tax rate the 33% federal income tax bracket might have netted only $42,075 from a prior to 2018 $75,000 dividend payment, assuming a 34% corporate tax rate and a 15% personal tax rate on qualiﬁ ed dividends. The combined effect of being taxed was 34% and at both the corporate and shareholder levels is a 44% liability – and that’s now stands before any potential state or local taxes are assessed. at 21%. New Tax Rates and Conversion Candidates New tax rates under the TCJA are impacting the “S or C corp” calculation. The top C corp federal tax rate prior to 2018 was 34% and now stands at 21%. The maximum personal income tax bracket today is 37%, down from 39.6% prior to 2018. While that might not seem like a big drop, income thresholds for the highest tax brackets are now signiﬁ cantly higher than before, so more taxpayers are being taxed at lower marginal rates.

Indeed, the tax math can add up in favor of C corp status for some business owners today when it didn’t before.

One business category whose owners might be strong candidates for converting from S to C corp status includes those falling under the “specifi ed service trade or business” (SSTB) heading of the 2017 tax law. SSTBs are pass-through businesses like Sub S corps involved in the fi elds of health, law, accounting, actuarial science, performing arts, consulting, athletics, fi nancial services, investing and investment management, among other categories.

What SSTBs have in common, according to the IRS, is their principal asset is the reputation or skill of one or more of their employees. Owners of such a business with personal taxable incomes (not adjusted gross incomes) in 2018 exceeding $157,500 as a single fi ler, or $315,000 as joint fi lers, are unable to claim the TCJA’s full 20% deduction of “qualifi ed business income” (QBI).

QBI is a measure of the pass-through company’s profi t, and in the case of an S corp does not include reasonable compensation paid to business owners. The tax math (Alternative formulas are available to determine your business’s QBI.) can add up in favor The QBI deduction amount is phased out for higher taxable income levels and fully eliminated for SSTB owners with 2018 taxable incomes exceeding of C corp status $415,000 (joint fi lers) and $207,500 (single fi lers). Those thresholds are for some business annually inflation-adjusted. Thus owners of S corps falling into the “specifi ed” business category who are above those income thresholds cannot reap the owners today when full rewards of the TCJA, possibly tilting the scales in favor of switching to C it didn’t before. corp status.

Another category of potential converts from S to C corp status is highly profi table businesses. In general, that’s because high profi ts attributed to S corp owners push them into higher tax brackets, with higher proportions of their income taxed at higher rates. Owners of C corps have the flexibility (within certain parameters) to allow profi ts taxed at today’s 21% corporate rate to accumulate within the corporation and be set aside for future needs.

20% QBI Deduction

Suppose, for example, your S corp is a “speciﬁ ed service trade or business” and you are ineligible for the 20% QBI deduction because your taxable income is above the $415,000 2018 threshold for joint ﬁ lers. Further suppose it logged $200,000 in QBI. Without the 20% QBI deduction, your federal tax hit would be approximately $70,000 on that amount, based on being in the 35% tax bracket.

Even if your Sub S were eligible for the 20% QBI deduction, you would still have sustained a substantial tax hit – $56,000 on that $200,000 of QBI.

S or C Corp Status? 2 In contrast, a C corp with $200,000 in taxable income, at the 21% corporate tax rate, could only receive a $42,000 tax bill. That would leave $158,000 in the C corp as retained earnings that can be set aside for future uses. As an S corp, if you were ineligible for the 20% QBI deduction, you would only have $130,000 remaining for future investment in your business.

C Corp Advantages

The potential $28,000 tax savings from C corp status in this simpliﬁ ed illustration doesn’t tell the entire story, however. The same potential advantages of C corp status relative to S corp status exist today as before the TCJA took effect in 2018. Those include:

■ Greater flexibility in the timing of taking proﬁ ts and losses for tax purposes, such as accelerating of deferred bonus income and raising or lowering other forms of executive compensation, including salaries, tactically.

■ Minimizing taxation on the value of employee beneﬁ ts such as health insurance. Highly proﬁ table ■ The ability to have multiple stock share classes, such as preferred in addition to common. businesses are

■ Being better positioned to attract investment capital from outsiders. (For potential converts example, S corps are limited to 100 shareholders.) from S to C Even so, C corps can have drawbacks compared to S corps. For example, corp status. maintaining C corps sometimes involves higher total legal and accounting expenses than maintaining S corps. Also, the basic appeal of S corps – elimination of being taxed at the corporate and shareholder levels – may still tilt the scales in favor of S corp status in many tax scenarios, even with the changes brought about by the TCJA.

Making Your Evaluation

Switching from S corp to C corp status involves revoking an S corp election and triggers a variety of accounting and tax issues that must be addressed. Tax professionals assisting in the process need to adhere to technical guidance from the IRS on such topics as the implications of switching from cash to accrual accounting, as spelled out in IRS Revenue Procedure 2018- 44. The timing of revoking S corp status needs to be carefully considered in light of tax implications both for the company’s primary shareholders and the corporation itself.

After analyzing the pros and cons of a conversion to C corp status based on your current circumstances, it’s also important to consider future “what- ifs,” such as the prospect of an eventual return to higher corporate tax rates. Although Congress fi nds it easier to cut taxes than to raise them, a future increase in corporate tax rates is not out of the question. That could negate the benefi ts of C corp status, depending upon the specifi cs.

S or C Corp Status? 3 On the other hand, the TCJA provisions pertaining to the tax cuts in individual tax rates are scheduled to “sunset” in 2026. That means individual tax rates will rise if Congress doesn’t act to keep those cuts in place. The same is not true for the corporate tax rate cut. Therefore, if personal rates do rise in 2026 and corporate rates remain low, the math favoring conversion to C corp status could become more compelling.

Another prospect to keep in mind is a gradual tapering off of your company’s taxable income, if you are winding down toward retirement. Under the post- TCJA tax bracket structure, the lower your taxable income, the narrower the potential tax savings from C corp status. Even a change in your status from ﬁ ling jointly to ﬁ ling as a single taxpayer could change the S versus C corp tax equation.

Switching from an S to a C and back to an S corp (known as a rescission) within a relatively short space of time could cause you to incur extra accounting and legal expenses that exceed your tax savings from the original switch to C status. It is therefore essential to consider the matter carefully and comprehensively. C corp status Seek Professional Guidance can better position Tax and specialized life insurance professionals can help you evaluate your business to all your options, including the possibility of pursuing an entirely different approach to tax minimization. For example, in some scenarios it can make attract investment sense for S corp owners to create a distinct corporation to provide services capital from to an S corp. Other potential business-related tax minimization strategies generally more practical with C corp status involve the use of corporate- outsiders. owned life insurance for tax-advantaged executive compensation and estate planning purposes. Indeed, when Congress overhauls the tax code, almost everything is on the table.

The information provided should not be considered as tax or legal advice. Please consult with your tax advisor and/or attorney regarding your individual circumstances. BB&T, Member FDIC. Only deposit products are FDIC insured. © 2019, Branch Banking and Trust Company. All rights reserved.

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