Since the President signed the Tax Cuts and Jobs Act on December 22, 2017, lowering the corporate income tax rate to 21%, one of the most frequent questions small business owners have had is “Should I convert to a C corporation?” The answer is “Perhaps, but we need to look at the big picture to know for sure.”
Under the pre-2018 rules, corporate and personal tax rates were relatively similar, and the second level tax of up to 20% on corporate dividends made C corporations tax inefficient compared to other forms of ownership. For this reason, in recent years most small businesses chose to be taxed as pass thru entities (S corporation, partnership, LLC or sole proprietorship) whose profits are taxed on the individual tax returns of the owners and whose dividends and distributions are not subject to a second level of taxation.
However, beginning in 2018 the new 21% tax rate is lower than five of the seven new individual tax brackets, and much lower than the 37% top individual bracket. This is creating new interest in C corporation taxation.
A second major provision of the Act is the creation of the new Section 199A deduction, which for the years 2018-2025 creates a new tax deduction of between 0% and 20% of “Qualified Business Income”, or QBI. QBI is non-C corporation trade or business income (S corporation, partnership, LLC or sole proprietorship) taxed on the owners’ individual tax return. It is also sometimes called “pass thru income.” This deduction is governed by a complex set of rules and limitations. These rules can create different results for different businesses or even for the same business based on the other items of income and deduction on the owner’s personal tax return.
Below are a few simplified examples of the interaction of the rules discussed above. They are for an entity with a sole owner actively running the business and are for illustrative purposes only. Actual results may vary due the presence of other items on a particular return.
A C corporation that pays dividends of 100% of its after-tax income to its stockholders can generate a total federal income tax of up to 36.8% (21% corporate tax plus 20% dividend tax at the personal level) and a pass thru entity whose income fully qualifies for a Section 199A deduction can generate a marginal federal income tax rate of up to 29.6% with no tax on distributions. Of course, lower tax brackets would reduce the tax rates.
An entity that pays dividends on 50% of its after-tax income and qualifies for only 50% of the Section 199A deduction has different results. If taxed as a C corporation there would be a total tax rate of up to 28.9% and if taxed as a pass thru entity there would be a marginal tax rate of up to 33.3% with no tax on distributions.
An entity that pays dividends on 75% of its after-tax income and qualifies for 75% of the Section 199A deduction has different results as well. If taxed as a C corporation there would be a total tax rate of up to 32.85% and if taxed as a pass thru entity there would be a marginal tax rate of up to 31.45% with no tax on distributions.
Many small business owners want to withdraw business profits to provide for the necessitates and luxuries of life, so they may want the ability to withdraw funds tax-free. Most growing small businesses need to retain profits to fund their growth. And some small business owners want to accumulate profits in the business. Each scenario has different impacts on a businesses’ plans to pay dividend distributions, which impacts whether it is preferable to be taxed as a C corporation or as a pass thru entity. So, choosing the most tax-efficient type of entity is not a simple choice but rather one determined by facts and circumstances.
Finally, if after consideration of the above conversion to a C corporation appears to be a good idea, there are additional considerations. If the business has intangible assets such as patents or goodwill, you may want to retain ownership of those assets in a flow thru entity in the event of a sale of the business. Not only would the flow-thru entity have a tax rate advantage (20% long term capital gain vs. 21% corporate tax), there would be no second layer of taxation of the sales proceeds if the transaction is an asset sale. Your attorney can draft the documents necessary to exclude intangible assets from the C corporation. Transferring liabilities in excess of the basis of assets could trigger the recognition of income. If the plan involves creating a new legal entity, contracts should be evaluated to see if they can be assigned to a different entity. These are just three of the several additional matters to be considered. Anyone considering a conversion should consult their business and tax advisors before taking action.