One of the significant changes made by the Tax Cuts and Jobs Act (TCJA) was to slash the top C corporate tax rate from 35% to a permanent flat 21% effective January 1, 2018. Individual tax rates were also lowered but not permanently with the highest tax bracket dropping from 39.6% to 37%. As a result, some S corporation owners may consider converting their business entity type to a C corporation to enjoy the lower 21% tax rate. This conversion decision should not be based solely on the difference in tax rates. Several factors need to be examined, and unfortunately, there is no "one size fits all" answer.
The TCJA implemented a 20% deduction for qualified business income (QBI) which will provide tax savings to many business owners including S corporation shareholders. This deduction lowers the effective tax rate of an individual in the top bracket and narrows the gap between the corporate rate and the individual rate.
Many S corporations make cash distributions to its shareholders. If a C corporation makes these same distributions, they are taxed as a dividend to the shareholders. This is the "double taxation" associated with C corporations - earnings are taxed at the corporate level at 21% and taxed again at the shareholder level as dividends with the regular tax rate being as high as 20% plus being subject to the 3.8% net investment income tax.
If the corporation does not plan to make shareholder distributions but to re-invest in the growth of the business, the C corporation structure may be more advantageous during this expansion phase. There are two potential additional taxes on C corporations that retain earnings. One is the 20% accumulated earnings tax which is assessed on retained cash that exceeds the company's "reasonable business needs." The other tax is the 20% personal holding company tax that applies to closely held businesses that receive at least 60% of its income from passive sources, i.e. interest, dividends, royalties, etc.
S corporations that revoke their S elections generally must wait five years before they can elect to be S corporations again. They would be subject to a five-year built-in gains recognition period upon reelection. S corporations wishing to revoke the S election must have written consent from shareholders owning more than 50% of its stock.
The TCJA contains a provision to allow S corporations that revoke their S elections within two years of the date of the TCJA's enactment (i.e., those that revoke by December 22, 2019) to distribute their accumulated S corporation earnings so that a portion is nontaxable. If the S corporation revokes its election after this two-year period, any distributions of accumulated S corporation earnings are fully taxable as dividends to the shareholders.
Other tax factors to consider include plans to dispose of business in the near future, treatment of fringe benefits, debt basis used by an S corporation shareholder to deduct losses, succession planning, and state, local, and international tax issues. There are also non-tax factors to consider such as the political side to tax legislation and whether these changes will be affected by the next major election.
Due to the uniqueness of each business and the complexity of the calculations with many factors to consider, a thorough analysis is required. We recommend you consult your HORNE tax advisor to assist you in making this decision.
About the Co-Authors
Maureen H. Scott, CPA, serves as a tax services director in the Ridgeland, MS, office. Maureen primarily works in the areas of individual, fiduciary and small business taxation.
Clay Crockett, CPA, is a manager at HORNE LLP where he specializes in tax services for individuals, partnerships and corporations.