Monica Sullivan, CPA and Partner at TDT, provides an overview between S and C Corporations and their associated tax reforms. Monica brings more than 23 years in diverse tax, financial, and business consulting experience to the firm. Monica specializes in serving privately held companies and their owners through comprehensive tax planning including significant experience in individual, corporate, partnership, estate and gift and trust taxation.
With the significant reduction of corporate tax rates from 35% to 21%, many S Corporation owners are asking themselves, is it time to make the change to C Corporation? Even though the top individual is reduced under Tax Reform to 37%, this is still a significantly higher amount than the new corporate rate. So, the change makes sense, right? Unfortunately, the answer is not quite that simple.
Depending on your industry, you may end up with a higher tax liability as a C Corporation, particularly manufacturers, distributors, and service industries.
While it’s simple to revoke your S election, the impacts of that revocation can have long-lasting implications and once revoked, you cannot revert to an S Corporation for at least five years.
Some of the factors that you should consider in your analysis:
New Deduction for Qualified Business Income
In exchange for not significantly lowering the tax rates for flow-through entities, the Qualified Business Income (QBI) deduction was created. QBI is essentially a 20% deduction for “qualified income.” However, not all S Corporations will qualify for the QBI deduction. Specific industries such as consulting firms, medical practices, and brokerage services phase-out of this deduction at certain thresholds. Even those entities that do qualify for the deduction are subject to limitations based on wages paid and cost of fixed assets in service
Cost of Retaining Cash
Many companies like to retain cash within the entity for future expansions and growth. The build-up of cash can have unintended consequences including a 20% accumulated earnings tax if the IRS deems the cash accumulation is excessive. Organizations structured as a personal holding company could also face additional taxes for undistributed income.
Double Taxation and Basis Built Up
C Corporation shareholders will continue to pay tax twice on the earnings of the C Corporation, once at the corporate level and again when the income is distributed to the shareholders. While the margin of additional tax is small, 39.8% in the case of a C Corporation vs. 37% for an S Corporation, if the S Corporation qualifies for the QBI deduction, the S Corporations rate would drop down to 29.6%. Additionally, C Corporation earnings do not create the additional basis for the shareholders.
Looking to the Future
You also must consider your long-term plans for the company. Do you intend to sell in the next few years? Are you looking to gift your interests to children? You should consider these questions before deciding to revoke an S election as they can have significant adverse effects on the tax consequences of those transactions.
Tax Reform, unfortunately, did not simplify the tax code and created more complexity to the S vs. C discussion. Let TDT CPAs and Advisors help you analyze the impacts to your business before making a change you may regret.