S Corp vs C Corp: Five Questions to Ask Before You Switch
The tax reform law commonly known as the Tax Cuts and Jobs Act made several adjustments to the tax treatment of business income. Two of the biggest include a new 20 percent deduction on qualified pass-through business income and a 14 percent permanent drop to the corporate income tax rate from 35 percent to 21 percent.
The changes have led many owners of pass-through entities to revisit their business’s entity structure for greater tax savings. While C corporation status has become relatively more attractive as a result of tax reform, there is no one-size-fits-all approach to entity selection.
For starters, a C corporation’s earnings are subject to two taxes: an entity-level tax and a shareholder-level tax when the earnings are eventually distributed. In contrast, a pass-through entity’s earnings are generally not subject to an entity-level tax. Instead, the earnings pass through on Schedule K-1 and are reported on the owner’s personal income tax return. The pass-through entity can then distribute those earnings on a tax-free basis.
However the benefit of the single level of tax of an S corporation needs to be weighed against another tax variable: The tax rate on S corporation income may be higher than the rate on C corporation earnings retained in the business.
To help determine whether you should switch from an S corporation to a C corporation, ask yourself the following five questions:
What is the effective tax rate on business income?
When evaluating entity choice, it’s tempting to compare the top marginal federal income tax rates of a C corporation (21 percent) with the top rate of a pass-through entity (29.6 percent for many and possibly up to 37 percent in some cases). But don’t fall for it.
Yes, the corporate tax rate is a flat 21 percent, but personal tax rates vary depending on your income, so you should compare the expected effective tax rate on business income rather than the top marginal tax rate. As long as your taxable income (without taking into account the business income) is less than $500,000 ($600,000 in the case of a joint return), the effective tax rate will be lower than 29.6 percent. For example:
A married couple has $190,000 of taxable wages, $435,000 of S corporation business income (all of which is eligible for the section 199A deduction), and no other items or income, deduction, or credit. The couple’s U.S. federal income tax liability is $131,279 if the business is an S corporation, and $28,419 if the business is a C corporation. The effective tax rate on the business income as an S corporation is 23.6 percent ($102,860 incremental tax liability ÷ $435,000 of business income).
In some instances, the effective rate on pass-through income will actually be lower than 21 percent.
What do you expect income tax rates to be in the future?
The reduced individual rates are set to expire after 2025, and the 21 percent corporate income tax rate does not expire. However, it is possible that Congress could tweak the corporate tax rate or extend individual tax cuts in the future. Since nobody has a crystal ball, consider the effect of future tax rate changes on your entity decision. It is easier to convert to C corporation status than to convert from C corporation status, so all other things being equal, a pass-through entity provides more flexibility to respond to future tax rate changes than a C corporation.
What are the short- and long-term plans for distributions to owners?
Some businesses may have a lower effective tax rate as a C corporation than as a pass-through entity. However, earnings of a C corporation may eventually become subject to a second level of tax when those earnings are distributed. If the earnings of a C corporation are distributed currently, the effective tax rate when taking into account the corporate- and shareholder-level taxes is 39.8 percent, which may be considerably higher than the tax rate as a pass-through entity. All other variables being equal, if you plan to take distributions from your business in the near future, then you may be better off operating your business as a pass-through entity. If you plan to reinvest earnings in the business for a significant number of years — deferring the second level of tax imposed on corporate distributions — then you may be better off operating your business as a C corporation.
Would earnings retained in a C corporation be subject to the accumulated earnings tax?
If a C corporation retains earnings beyond the corporation’s reasonable business needs, the IRS can impose a 20 percent accumulated earnings tax on the excess. Reasonable business needs may include debt retirement, business expansion, acquisition of another business, and working capital, among others. The tax has been assessed infrequently because C corporations have historically been incentivized to avoid double taxation by minimizing corporate taxable income rather than accumulating earnings in the corporation. This is likely to change in response to the new lower tax rates.
The tax is in addition to the corporate-level income tax and the shareholder-level tax that will eventually be imposed when earnings are distributed, which results in triple taxation of corporate earnings. The tax does not apply to pass-through entities. If the tax would apply, the corporation might be better off either operating as a pass-through entity or distributing earnings to avoid the tax.
How and when do the owners plan to transition the business?
The second habit of Dr. Stephen R. Covey’s Seven Habits of Highly Effective People is to “begin with the end in mind.” If you are like many business owners, a significant portion of your wealth is invested in your business, and you plan to use that value to finance your retirement. As part of entity structure planning, you will want to begin with the end in mind and consider the impact the structure will have on the after-tax cash flow from an eventual business sale.
Generally speaking, the after-tax cash flow from the sale of a pass-through entity is higher than from the sale of a C corporation. However, in some instances the gain from the sale of C corporation stock may be exempt from tax, so an analysis of your particular circumstances would be required to evaluate the pros and cons of different structures for your business.
How we can help
Like other aspects of business planning, entity structure planning occurs in an environment of uncertainty. While only time will tell whether the selected tax structure for a business was the best one from a tax perspective, careful planning and consideration of the questions above will help improve the odds of selecting a structure that meets the needs of the business and its owners. CLA tax professionals can help you evaluate these factors. We can model the after-tax cash flow as a C corporation and as a pass-through entity to help you decide how to structure your business.