When the Tax and Jobs Act of 2017 was signed into law by President Trump, it was the most significant change to tax policy our country has seen in more than 30 years.
One area particularly impacted by it was how certain corporations classify themselves, namely with C-corporations (where profits are taxed separately from the company's owners) and S-corporations (which are pass-through entities, taxed at the individual owners level).
When the new tax law took effect, a much lower, flat corporate tax rate of 21% was adopted, which had a direct positive impact on C-corporations. So much so, in fact, that it led many owners of S-corporations to consider changing their corporate status to a C-corp to take advantage of such a significant reduction.
However, the simple fact is unlike the tax cut of 1986, which was much more all-encompassing, the Tax and Jobs Act of 2017 is much more nuanced and complicated. And the decision to convert from an S-corp to a C-corp may or may not be the right move, depending on a number of factors.
Why Converting to a C-corp May Be the Right Thing
The most obvious advantage of converting to C-status is that new 21% tax rate, which when compared with the new top individual income tax rate of 37% offers what is obviously a substantial savings for the owners.
For business owners who don't have a strong need for access to cash right away, there could indeed be a major advantage to converting to a C-corp.
Additionally, because pass-through S-corp owners pay state taxes on a personal level, and personal itemized deductions of state taxes are now capped at $10,000, there could be much less of an incentive to remain an S-corp.
What is clear about federal tax reform is the one-size-fits-all approach has evolved into one-size-fits-one.
Lastly, there is what is known as the Qualified Small Business Stock Exclusion, in which a qualifying owner may be able to exclude 100% of gain upon the sale of the business stock. This would allow an owner to avoid double taxation from a C-corp, and would highlight that coveted 21% tax rate.
So clearly there are advantages; the challenge for existing S-corps now is to determine whether the time for such a conversion is right.
Why Converting to a C-corp May Not Be the Right Thing
Conversely, there are still solid reasons for companies to maintain their S-status, especially if the business will qualify for the new 20% Qualified Business Income deduction. And let us not forget there is the reality that C-corp owners will likely have to pay two layers of taxes, namely if they are paying wages or paying dividend distributions to themselves.
Also a concern, if the owner plans to sell the company within the next few years, it could make sense to remain a pass-through entity (assuming the QSBS exclusion will not apply).
For businesses dealing with losses, owners should keep in mind that in a C-corp, those losses stay within the business, whereas with an S-corp the losses could be used to offset other personal income. With C-corporations, no such benefit exists.
Finally, there is the potential burden of unintended consequences, particularly if the business has accumulated a significant amount of cash and/or invested that cash. In that case, the owner of a C-corp could have to pay extra taxes that an S-corp owner would not, specifically the Accumulated Earnings Tax and the Personal Holding Company Tax. So again, careful examination is required before rushing into anything.
What is clear about the implementation of the Tax and Jobs Act is the one-size-fits-all approach we saw in 1986 has evolved into one-size-fits-one.
And it takes much more than a simple surface examination to determine if changing from an S-corporation to a C-corporation is the right move. As is customary in the business world, companies that take a complete look at the pros and cons will be the ones that ultimately come out ahead.
About the author: Corey Veneziano is a tax partner with West Hartford-based blumshapiro, the largest regional business advisory firm based in New England. This article first appeared in the Hartford Business Journal on Jan. 7, 2019.