Reasons why now may not be the time to convert to a C corp

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There are cases where businesses should restructure for tax purposes and, on first glance, the new rules in the Tax Cuts and Jobs Act may make the C corp option look more attractive than it actually is.

Mark E. Lumsden, CPA
Tax partner, ACM, Boulder

Structuring as a C corporation is certainly the best choice for many businesses; for most small, closely held companies, however, a “pass thru” structure has long been considered a more tax-efficient option. For the 2015 tax year, the number of returns filed for S corporations and partnerships outnumbered C corp filings nearly four to one, according to the Internal Revenue Service. But with the massive changes that came with passage of the Tax Cuts and Jobs Act of 2017, including the historic cut to corporate taxes from a maximum federal rate of 35 percent to a flat 21 percent, many of these small-business owners are wondering if C corporations deserve a second look.

Why was there such a turnoff to C corporations in the first place? The most notable reason is that C corps generally are subject to two layers of taxation. This is because the corporation must pay income tax on its profits, and when these profits eventually are distributed to the company’s shareholders, the dividends are taxable at the shareholder level. One often-used tool to avoid paying dividends is to simply pay out bonuses to shareholder-employees.

These bonuses are taxable to the employee but deductible to the corporation, creating only a single level of tax. However, the bonuses also are subject to payroll taxes, which, while possibly lower than the tax on dividends, still creates an additional tax burden for paying out profits. In contrast, a pass-thru entity generally pays no income tax. The income is reported and the tax is paid by the entity’s owners, and then the distribution of those profits generally is tax-free. The new rules did not change the fact that dividend payments from a C corporation are taxable to the shareholder, but with the lower corporate rate, could this double-taxation still result in a lower overall tax bill?

Possibly … but, as it turns out, probably not.

One reason why we may not see a C corp renaissance is the new pass-thru income deduction that was included in the tax reform, but not widely discussed on the mainstream news. This deduction allows many owners of businesses taxed as S corporations, partnerships and sole proprietorships to deduct up to 20 percent of their income from these activities, effectively making 20 percent of these business profits tax-free. Of course, each individual situation will be different, but let’s compare a few basic scenarios.

For high-income taxpayers who qualifies for the full pass-thru deduction on a business they’re actively involved with, they will effectively see their marginal tax rate on their business income reduced from the top rate of about 41.6 percent (including Colorado tax) to about 33.3 percent. This is still higher than the 24.7 percent effective corporate rate (again, including Colorado tax), but take into account a 24.6 percent combined federal and state tax paid on the dividend, and the effective rate would be about 43.2 percent – a rate differential of nearly 10 percentage points. Additionally, this example doesn’t take into account the 3.8 percent net investment income tax that could be assessed on the individual’s dividend income, causing the difference in tax to be even greater. For more modest income taxpayers, the difference in effective rates grows as their individual tax bracket decreases.

Those familiar with the new pass-thru deduction are aware that there are limitations and phase-outs for service-based businesses or companies that pay little or no wages to employees. Even if we repeat the high-income taxpayer scenario above but assume he doesn’t qualify for a pass-thru deduction at all, his marginal rate would be 41.6 percent, still slightly lower than the 43.2 percent effective rate in the C corp scenario.

One could argue that the owners of a C corp don’t have to distribute the profits of the business and, by leaving them in the company, only pay the corporate tax. This is certainly a valid argument but doing so could create a tax trap. Mainly, if the C corporation accumulates undistributed earnings beyond the “reasonable needs of the business,” the business could be subject to the “accumulated earnings tax.” This is a 20 percent tax on these excess undistributed earnings and is designed to penalize a corporation for avoiding tax by not distributing its profits.

“Reasonable needs of the business” is a subjective term, but businesses are allowed to retain a minimum of $250,000, or $150,000 for service-based businesses. So, while this strategy may allow for some deferral of tax, business owners should be careful to avoid keeping too many profits in the business and ending up paying even more tax as a result.

With so many changes in the new tax reform, we recommend all business owners discuss their situation with a qualified certified public accountant to make sure their business structure and strategy aren’t outdated. There are cases where businesses should restructure for tax purposes and, on first glance, the new rules may make the C corp option look more attractive than it actually is. Do yourself a favor and make sure to look at the big picture and the overall tax effect to the business and its owners before deciding on any such changes.

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