If you do a quick read of the Tax Cuts and Jobs Act (TCJA) you’ll see that the new C Corporation tax rate is 21% while the top individual rate is 37%. Also, individuals are allowed a 20% deduction for passthrough income. Given these basics, many taxpayers are wondering whether they should convert their passthrough businesses, such as partnerships, LLCs, and S Corporations, into a C Corporation to take advantage of the lower fixed rate.
While such a move may be advantageous for some, the decision is a complex one and must be customized to your particular business activities. Let’s explore some of the issues surrounding the difference in the tax treatment of passthroughs and C Corporations under the new law and examine the idea of C Corporation conversion.
Review of TCJA Business Rates
The TCJA reduces the corporate tax rate from 35% to a flat 21% rate with no brackets, beginning in 2018. It also repeals the corporate alternative minimum tax (AMT). Although the law makes significant changes to the treatment of partnerships, LLCs, and S Corporations, there is no maximum rate for passthrough businesses. Instead, the new law reduces the top individual rate to 37% and allows a 20% deduction for passthrough income. The combination of these two tax provisions results in a top 29.6% tax rate for passthrough income. The individual AMT is retained but the exemptions are increased so more taxpayers can avoid it. The corporate and passthrough rate reductions are permanent while the individual provisions are temporary only, expiring after 2025. Against this backdrop, here are some of the issues involving in converting to a C Corporation.
Corporations Still are Double-Taxed
While the 21% corporate tax rate is potentially lower than the 29.6% passthrough income rate, corporations are still taxed at two levels, the entity level and the shareholder level. The entity pays income tax at 21% and shareholders pays 0% to 20% on dividends paid out, depending on their income level. Dividends also are subject to the 3.8% net investment income tax, if the taxpayer’s adjusted gross income (AGI) exceeds $200,000 for singles or $250,000 for joint filers. So, the corporate double-tax narrows the rate differential between C Corporations and passthroughs.
If your long-term business plan is to not pay out dividends, however, the C Corporation option may be more advantageous. Profits that are reinvested in the corporations are not double-taxed, so the lower corporate rate and the growth of the corporation’s value could be a better bet for owners. Beware, however, of the C Corporation accumulated earnings tax—a 15% tax on earnings held in the business beyond its reasonable needs.
Also note that corporations can deduct all state and local taxes, but individuals are subject to the new $10,000 limit for all state and local taxes combined. This rule favors the C Corporation form.
Sole proprietors may consider incorporating to shield some of their compensation from the higher individual rates, 37% for individuals but just 21% for corporations. This strategy could work well if the owner has the flexibility to time dividend payments for low tax years.
Better Fringe Benefit Options for C Corps
C Corporations traditionally have access to more tax-favored fringe benefits than passthroughs, particularly for owners. More than two-percent owners of passthroughs cannot exclude most fringe benefits paid by the firm, including the cost of group-term life insurance, accident or health plans and meals and lodging furnished for the convenience of the employer. A C Corporation, on the other hand, can deduct the costs of health insurance for owner-employees, employee-owned vehicles, life insurance plans, long-term care plans, etc., and also have more options on retirement plans. Owner-employees of C Corporations get these benefits tax free.
Passthrough Benefits and Drawbacks
The 20% passthrough deduction under the TCJA is not a sure thing. Included in the law are complex anti-abuse rules that limit the availability of the deduction based on income level, the type of business, the amount of wages paid out, and the amount of depreciable property held by the business. For professional service firms, such as law firms, CPA firms, and investment firms, the full deduction is not allowed unless the owners’ taxable income is less than $157,500 for single filers and $315,000 for joint filers. If a taxpayer is above these income levels, the deduction is reduced as income rises and is completely lost when a taxpayer gets to $207,500 in taxable income for single filers and $415,000 for joint filers. When a taxpayer hits these upper limits, income flowing through is fully taxed at individual rates up to 37%. (Note that engineering firms and architectural firms are not subject to the professional service restrictions.)
For taxpayers who are not in the professional services business, restrictions on the deduction can be avoided if the business has high W-2 wages or holds significant depreciable assets.
Against this backdrop, a key planning point regarding the new tax regime is this: if you are below the $157,500/$315,000 income thresholds for limitations on the passthrough deduction, there is no need to convert to a C Corporation. If your income is above these levels and your business has low W-2 wages and few depreciable assets, there may be a tax benefit to becoming a C Corporation because you are unlikely to be able to take full advantage of the 20% passthrough deduction.
Also, for C Corporations, losses do not passthrough to owners, while passthrough owners get to use the entity’s losses to offset other income on their returns. This factor favors the passthrough entity form.
Conversions Could be Costly, Difficult
Depending on how much tax you can save, converting to a C Corporation may not be worth it. It can be expensive and time-consuming to convert to a C Corporation under state law, if you are an LLC or a partnership. S Corporations can revoke their status and become a C Corporation if a majority of shareholders agree to it. Most firms use lawyers to incorporate and help them draft a set of articles of incorporation, bylaws, name corporate officers and directors and issue stock certificates. Thus, the legal fees can be a factor.
Many states, like Georgia, have a streamlined process for this conversion, but some states do not. In Georgia, “statutory conversions” are possible, which automatically transfer an LLC’s assets and liabilities to a new corporation. Only a few documents need to be filed with the Secretary of State. Under this procedure, you also do not need to dissolve your LLC.
Another problem is if your company wants to revert back to a passthrough entity. State procedures can be cumbersome, and, for S Corporations, the IRS will not allow a new S election for five years. Thus, for logistical reasons, the decision to change your business entity cannot be taken lightly and should be made as part of a careful long-range plan.
S Corp Payroll Advantage
For S Corporations contemplating a move to C status, the issue of payroll taxes can be a big deterrent. S Corporation owner-employees can set their salaries and profit amounts in a way that minimizes payroll taxes. Of course, there are restrictions on how you characterize income. The salary paid an owner must be “reasonable compensation” but the rest of earnings can be passed through and reported as business profits not subject to payroll taxes–social security and Medicare. For high-income earners, the savings on Medicare taxes can be significant, now that their Medicare tax rate is 2.35%. If you convert to a C Corporation, all salary income will be subject to full payroll taxes and dividends could be subject to the 3.8% net investment income tax.
Splitting Your Business Entities
Some commentators are recommending that you consider splitting your company into two separate businesses. This works if you can easily bifurcate your business activities and your employees. For example, part of the business may provide professional services, like consulting, and part could hold rental real estate or offer computer and database functions. In that way, the consulting income could be taxed once under the passthrough rules and the real estate and database income could get the 21% corporate rate.
Here are some key points regarding choice of entity under the TCJA.
● If you are a professional service firm under the income levels for phaseout of the passthrough deduction, there is no need to convert to a C Corporation.
● If you are in danger of losing the passthrough deduction, with low W-2 income and few depreciable assets, converting to a C Corporation could be advantageous, particularly if you can minimize the dividend distributions.
● The costs of converting an entity can be expensive and difficult, depending on your state laws. Also, once a change is made, it may be difficult to covert back if the tax laws change yet again or if your business model shifts.
As you can see from the previous discussion, the issue of converting your business into a different entity under the new tax bill is a complex one. For every advantage presented, there are caveats. Also, tax considerations are not the only factor. Although there is a lot of free advice available on how to restructure under the TCJA, the solutions presented are not for everyone. It takes a careful analysis of your business and your long-term goals to select the right option. Professional business and tax advisers should be engaged to ensure you make the right move, if any.