Corporation type decision based on tax reform

A closer look at C Corp. v. S Corp. following federal tax reform

After the TCJA, C Corporation income tax rate was reduced dramatically, tempting business owners to change their business structures.

The primary driver of the Tax Cuts and Jobs Act (TCJA) was the perceived necessity to lower C corporation income tax rates to be more competitive on a global scale. This was accomplished by reducing the C corporation income tax rate to a flat 21%.

On the other the hand, top individual income tax rates dropped only to 37%. Many people quickly assumed changing their business structure to a C corporation was an easy decision. Not so fast! There are numerous items to consider before changing from an S corporation to a C corporation, and the items discussed below are just a few examples.

Items to consider

As part of the TCJA, taxpayers with flow-through business income were provided a new 20% qualified business income (QBI) deduction that may be taken on their individual tax return. The QBI deduction applies to many businesses, but does contain some limitations based on type of income and amount of wages paid. This flow-through deduction may effectively reduce the top tax rate on this business income to 29.6% if the income qualifies for the deduction.

In addition, C corporations continue to face double taxation at the shareholder level upon paying dividends out to their shareholders. The qualified dividend tax rate would most likely be 20%. In addition, the dividends may be subject to the 3.8% net investment income tax depending on an individual’s overall taxable income and involvement with the C corporation. Contrast that with S corporations, which are allowed to pass out shareholder distributions tax free to the extent of previously taxed S corporation income.

Any undistributed S corporation taxable income also increases the shareholder’s basis in their ownership. A C corporation shareholder does not receive a similar treatment to their share basis. Thus, a shareholder could have less taxable gain upon the disposition of their ownership interest if the entity was an S corporation. Even if the C corporation sells the company as an asset sale, it results in two levels of tax. First, the regular C corporation tax on the gain from the sale of the assets and second, tax on the liquidation of the cash out to the shareholders with their low share basis.

However, if the C corporation is closely held and there is a succession plan upon the owner’s death, the stock receives a step-up in basis to fair market value. Thus, the taxable gain on selling of the entity would be reduced. This same step-up in basis can apply to S corporations as well.

There is a new limitation on an individual taxpayer only providing the ability to deduct a maximum of $10,000 of state and local taxes. In most situations, the business owner would get little benefit on the state tax paid on the flow-through taxable income. Whereas, C corporations may continue to fully deduct all state taxes paid against the federal taxable income.

An S corporation business must consider other future risks of switching to a C corporation. This includes the fact that a corporation which terminates its S corporation treatment cannot switch back for five years. So, a switch would include betting that the current taxing scenario does not change with future congressional and presidential election. Also, if the corporation decides to re-elect S status in the future, the exposure to built-in gains tax starts over for a new five year period. The tax planning around avoiding built-in gains tax is now also limited with personal property not being eligible for deferral of taxable income under like-kind exchange treatment.

Need more information?

For more information contact Rick Golubski using the information below.

Rick Golubski

Vice President
Tax Services

Rick Golubski is a certified public accountant, with extensive experience in the fields of accounting, auditing, and taxes and frequently works with clients in the banking industry. He graduated from Emporia State University with a business degree.

Rick is a member of the Kansas Society of Certified Public Accountants, the American Institute of Certified Public Accountants, and the local chapter of the Construction Financial Management Association, including serving previously on the CFMA board of directors. He joined AGH in 1994 and has served in leadership positions in both audit and tax at the firm. He has been honored by the Wichita Business Journal as a “40 Under 40” young community leader and currently serves on the board of the Harvey County United Way.

NOTE: Any advice contained in this material is not intended or written to be tax advice, and cannot be relied upon as such, nor can it be used for the purpose of avoiding tax penalties that may be imposed by the IRS or states, or promoting, marketing or recommending to another party any transaction or matter addressed herein.

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