Are C Corporations More Attractive Now that the Rates Have Dropped?

(How the 2017 Tax Cuts and Jobs Act impacts choice of entity)

Introduction

After the Tax Cuts and Jobs Act (Act) was signed into law on December 22, 2017, many business owners have been concerned about the potential impact of the Act on them and their businesses, and many took a renewed interest in whether their current entity type still makes sense. The Act generated a lot of publicity surrounding the large tax rate reduction for C Corporations, which was reduced from graduated rates topping out at 35% to a flat rate of 21% for tax years starting after 12/31/2017. With the top individual rate at 37%, taxpayers may assume that C Corporations now hold a tax advantage, and believe they should take action to have their S Corporations, partnerships, and LLCs taxed and treated as C Corporations for federal income tax purposes going forward. While every taxpayer’s set of facts and circumstances differ, the remainder of this article will try to shed some light on this assumption and the true effect of the Act on businesses going forward. It will discuss all of the most common forms of business, but focus heavily on S Corporations vs. C Corporations.

Background – the choices

When a new business is started, taxpayers have a variety of options for how to structure the entity for federal tax purposes. The most common entity forms include C Corporations, S Corporations, Partnerships (including Limited Liability Companies (LLCs)), and Sole Proprietors (including single-member LLCs (SMLLCs)). There are many differences between the various entity forms and several tax consequences to consider; below is a basic comparison listing just a few.

C Corporations S Corporations Partnerships (including LLCs) Sole Proprietors (including SMLLCs)
Where is the tax on the income of the business paid? Corporate level Individual level Individual level Individual level
Maximum federal tax rate of business income 35% before 12/31/17; 21% starting 1/1/18 39.6% before 12/31/17; 37% starting 1/1/18 (effective rate could be less due to possibility of 20% pass-through deduction) 39.6% before 12/31/17; 37% starting 1/1/18 (effective rate could be less due to possibility of 20% pass-through deduction) 39.6% before 12/31/17; 37% starting 1/1/18 (effective rate could be less due to possibility of 20% pass-through deduction)
Are distributions to the owner(s) generally taxable? Yes No No No
Maximum federal tax rate of distributions 20% + 3.8% NII surtax n/a n/a n/a
Number of owners allowed 1 or more 1-100 2 or more 1
Types of owners disallowed None Corporations, nonresident aliens, partnerships, certain trusts None None
Are multiple classes of ownership allowed? Yes No, only one class of stock is allowed although there may be differences in voting rights Yes n/a

For several years now, the general consensus has been that for tax purposes, new businesses are better off forming as pass-through entities rather than C Corporations. This opinion has stemmed from a few primary considerations:

Operational income

First, income generated by pass-through entities is taxed at the individual partner or shareholder level, whereas income generated by a C Corporation is taxed at the entity level. Although the top individual rate exceeds the top corporate rate, sometimes the amount of income and the owner’s tax bracket results in income of pass-through entities being taxed at lower rates than C Corporations. If distributions of cash are made from those same earnings, the distribution is taxed again by C corporation shareholders, while it generally is tax-free to pass-through entity owners. In other words, C Corporation income, if actually distributed, is taxed twice. Pass-through income generally is taxed once.

Cashing out

Even for businesses that do not distribute cash to owners, C Corporations often produce double-taxation down the road when a company is sold. Shareholders who can convince a buyer to acquire their stock will enjoy only one level of taxation, assessed at the individual level and likely at favorable (long-term capital) rates. But buyers often prefer to acquire assets from the company rather than stock from its owners; it allows the buyer to more quickly write off the cost of their investment (through depreciation, etc.), and helps them avoid unknown liabilities they could inherit if acquiring stock.

If a pass-through entity sells assets, the gain is taxed at the individual level, just like operational income described above, and some income may qualify for a favorable long-term capital gain rate. When the cash proceeds are distributed, much (sometimes all) of it is tax-free. When a C Corporation sells assets, gain is taxed at the entity level, where no favorable capital gain rates exist. When the cash proceeds are distributed, generally all but the shareholder’s original investment is taxable. Once again, C Corporation income is usually taxed twice, and pass-through income generally is taxed once.

Flexibility

Some pass-through entities (specifically LLCs and partnerships) offer much flexibility when it comes to the allocation of income, deductions, debt, and distributions among members and partners. This increased flexibility is often enticing when compared to the C Corporations, which make no allocations; and S Corporations, which must allocate to all shareholders based strictly on ownership percentage.

Self-employment tax applies to sole proprietors and owner/operators of many partnerships and LLCs, but not S Corporations or C Corporations. This did not change under the Act.

Analysis – the impact of tax reform

Don’t Forget About the Pass-Through Deduction and Double Taxation

At first glance, the decreased corporate tax rate of 21% looks advantageous compared to the maximum individual tax rate of 37%. However, distributions made to C Corporation shareholders remain taxable as dividends at the individual level. For purposes of this example we’ll assume that earnings will be distributed out of the entity. Another important factor to consider is a completely new deduction that can be applied to qualified business income of pass-through entities for tax years beginning after December 31, 2017. You can read more about the deduction in a related article but for purposes of this example we’ll assume that a 20% deduction will be allowed on the pass-through income. The following example illustrates the differences if the entity is formed as an S Corporation or C Corporation, while also comparing the impact of the law change from 2017 to 2018.

Example 1:

S Corporation C Corporation
2017 2018 2017 2018
Net Income $800,000 $800,000 $800,000 $800,000
Flow-through QBI deduction n/a $(160,000) n/a n/a
Taxable Income $800,000 $640,000 $800,000 $800,000
Income Tax on Business Income $316,800 $236,800 $280,000 $168,000
Income Tax on Distributions (net income less income tax on business income) n/a n/a $123,760 $150,416
Total Tax $316,800 $236,800 $403,760 $318,416

Assume the same facts as Example 1 except now we’re analyzing a manufacturing business that prior to 2018 had qualified for the Sec. 199 Domestic Production Activities Deduction (DPAD), which is repealed for tax years beginning after 12/31/17. The owners of this business also have other means of income and have agreed that no distributions will be made, leaving it all in the company to help with growth and expansion over the next several years.

Example 2:

S Corporation C Corporation
2017 2018 2017 2018
Net Income $800,000 $800,000 $800,000 $800,000
DPAD $(72,000) n/a $(72,000) n/a
Flow-through QBI deduction n/a $(160,000) n/a n/a
Taxable Income $728,000 $640,000 $728,000 $800,000
Income Tax on Business Income $288,288 $236,800 $254,800 $168,000
Income Tax on Distributions (net income less income tax on business income) n/a n/a n/a n/a
Total Tax $288,288 $236,800 $254,800 $168,000

Assume the same facts as Example 1 except now we’re analyzing a consulting business. This is relevant because the new 20% pass-through deduction is not allowed for certain “specified service businesses” (like consulting) once the owner’s income reaches certain levels (like the ones in our example).

Example 3:

S Corporation C Corporation
2017 2018 2017 2018
Net Income $800,000 $800,000 $800,000 $800,000
Flow-through QBI deduction n/a $(0) n/a n/a
Taxable Income $800,000 $800,000 $800,000 $800,000
Income Tax on Business Income $316,800 $296,000 $280,000 $168,000
Income Tax on Distributions (net income less income tax on business income) n/a n/a $123,760 $150,416
Total Tax $316,800 $296,000 $403,760 $318,416

As previously stated, each business situation is different and the underlying analysis will greatly depend upon the facts and circumstances. To what extent the pass-through deduction will be allowed on the business income and to what extent there is a need to distribute earnings from the business should be highly considered when analyzing your situation.

Is This A Long-Term or Short-Term Business Plan?

It may be easy to talk yourself into a conversion simply by running a quick scenario like the ones above and determining that under the Act, you’ll likely be subject to less tax as a C Corporation. While the thought of immediate (and permanent) short-term tax savings is very enticing, it is also important to consider the long-term consequences of a conversion like this. There likely would be no immediate taxable income recognized upon the conversion, although if you have an LLC or partnership with liabilities in excess of assets it is possible that gain must be recognized on the excess. For purposes of this article we’ll assume no such gain would be generated.

It is also important to note that while the decreased C Corporation rate is permanent, the majority of provisions in the Act are set to expire with tax years beginning after December 31, 2025, including the changes to individual rates and the pass-through deduction. Therefore, it is possible that the changes in tax rates and deductions could reverse in eight years. Or it is possible there could be an extreme flip to the opposite, greatly favoring pass-through entities even more than they were before the Act. Or , less likely, but possible, C Corporations could become even more taxpayer-friendly than they are now. Or… really the possibilities are endless and the point is that there is no permanency guaranteed with the tax law. Unlike the conversion to a C Corporation, conversions from a C Corporation to a pass-through entity could have greater ramifications.

Switchbacks

If you revoke a current S election, you cannot elect S status again for 5 years. Therefore, if you operate an S Corporation now and make a conversion, you should be certain you will want to remain a C Corporation for at least the next five years. (Note that a revocation of an S Election needs to be filed within 75 days of the start of the tax year in which you want the revocation to be effective. Therefore, any taxpayer considering making a revocation for the tax year beginning 1/1/19 must do so by March 15, 2019. If this deadline is missed, the revocation would become effective on the first day of the following tax year.) Even after 5 years if you decide you want to elect S status again, you could be presented with challenges and possible exposure to built-in-gains tax, which “captures” C Corporation tax on sales of assets held at the time of conversion, if sold within 5 years after the new S election. (This rule sort of treats the S Corporation unfavorably as a C Corporation for a bit longer – but only as it relates to sales of assets held when converted.)

This section may get a bit technical for some readers. S Corporations that revoke their elections also have a 1 year window in which they can distribute out their Accumulated Adjustments Account (AAA) as tax-free distributions to the owners. (This rule allows a cash-rich entity to be favorably treated as an S Corporation for a bit longer – but only as it relates to distributions.) This short window has the potential to cause companies that have large AAA balances but no current means of cash flow to distribute that balance within a year. After the 1-year window is up, any distributions will be taxable to the owner as a dividend like normal C Corporation distributions. Even worse, a potential conversion back from a C Corporation to an LLC will have immediate tax consequences due to the fact that this type of conversion is deemed to be a liquidation of the corporation with a transfer of all assets to a new entity. The deemed liquidation will likely cause taxable gain to be recognized at the corporate level as well as the shareholder level.

Cashing out

The last thought to consider is the potential sale of your business. Perhaps one of the biggest disadvantages of C Corporations compared to pass-through entities is the tax burden associated with an asset sale. Many buyers in a sale transaction will prefer to buy the assets of a business rather than the underlying ownership interests in the business. In this situation, operating as a C Corporation could cost you much more in taxes because the corporation will not only recognize gain or loss on the sale of the assets at the entity level, but once the proceeds are liquidated to the owners, the owners will also recognize gain on their liquidating distribution. This is not the case with pass-through entities since the gain or loss is recognized at the individual level (at capital gains rates), and often no additional tax will be paid by the member or shareholder on their liquidating distribution.

Example 4:

S Corporation C Corporation
2017 2018 2017 2018
Gain from the sale of assets $6,000,000 $6,000,000 $6,000,000 $6,000,000
Income Tax on Gain $1,200,000 $1,200,000 $2,100,000 $1,260,000
Income Tax on Distributions (proceeds of $12 million less income tax on gain) n/a n/a $2,356,200 $2,556,120
Total Tax $1,200,000 $1,200,000 $4,456,200 $3,816,120

This final example is meant to illustrate a more complete picture. We will use the facts in Example 2 where being a C Corporation looks to be more advantageous over the next several years. But we will also add the following facts:

  • After another 4 years, the owners are presented with a deal from a group of buyers that is too good to refuse. The buyers will only purchase the assets of the company. Since the current owners have re-invested so much into the company there has been a lot of growth; the expected gain on the sale of the assets will be $6,000,000 from proceeds of $12,000,000 (as outlined in example 4).

Example 5:

S Corporations C Corporations
2018-2021 2018-2021
Increase in stock basis from net income (Example 2) $3,200,000 n/a
Increase in stock basis from sale of assets (Example 4) $6,000,000 n/a
Decrease in stock basis from liquidating distribution $(12,000,000) n/a
Additional Gain upon liquidation $2,800,000 $0
Additional Tax upon liquidation $560,000 $0
Total Tax from business operations (Example 2) $947,200 $672,000
Total Tax from sale of assets (Example 4) $1,200,000 $3,816,120
Total Tax over 4 years $2,707,200 $4,488,120

It is also important to note that in the event the sale is of the underlying ownership interests in the business (stock) and not assets, C Corporations could actually have an advantage. In this situation there would be no taxable income recognized at the entity level and all gain would be calculated at the shareholders’ individual level (and subject to capital gains rates). Even better, sometimes gain from the sale of qualified small business stock can be excluded from income under IRC §1202. An entire article could be written on this topic, but generally speaking, for shareholders who are not corporations and have held qualified small business stock for at least 5 years, up to 100% of the gain on the sale of that stock can be excluded from taxable income. Therefore, if you are certain that your exit from the business can be accomplished in the form of a stock sale, rather than an asset sale, the use of a C Corporation may be more attractive. (Even then, most buyers are willing to pay less if acquiring stock instead of assets, so a truly comprehensive analysis would somehow need to account for that as well.)

Conclusion

While the Tax Cuts and Jobs Act has certainly made C Corporations more appealing than they have been in past years, taxpayers currently operating as pass-through entities need to take a careful look at both their short-term and long-term business goals and ask themselves several key questions before considering the switch:

  • To what extent will I be able to utilize the pass-through deduction if the entity remains as is?
  • To what extent will I need to take distributions from the entity?
  • Do I have a goal of selling the business?  If so, how many years from now?

In general, while the gap between the top individual rate and the lower corporate rate is now more pronounced, the gap may not be large enough to overcome the impact of the double taxation that applies when C Corporation earnings are distributed to shareholders.

Every business will have its own unique set of facts and circumstances and every group of owners will have unique goals and objectives. For these reasons, there is no one-size-fits-all answer and each situation should be carefully analyzed and evaluated to ensure that the best entity structure is maintained.

If you have any questions regarding the Tax Cuts and Jobs Act and its impact on your current entity structure, please contact your BNN tax advisor at 800.244.7444.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

Kelly Huggins Posted By
Kelly Huggins

Posted Under: Tax Cuts & Jobs Act, Tax reform

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