Should you convert your S Corporation to a C Corporation? Under the recent federal tax act, the highest corporate income tax rate in 2018 will be 21%. That is significantly lower than the highest individual income tax rate of 37%. This significant rate variation creates the possibility of significant income tax savings for certain businesses that operate as a C corporation. But there are several factors that could counter the potential tax savings created by the lower corporate income tax rates that must be considered. First, the individual income tax rates start at only 10% and then gradually increase to the maximum 37% level as the amount of income increases. Second, the recent tax act added a new deduction for pass-through income. Third, revenue generated by a C corporation that is subsequently distributed to shareholders as a dividend is subject to double taxation.
Graduated Individual Tax Rates. The individual income tax rates start at only 10% and then gradually increase to 37%. Most pass-through businesses will not generate enough income to allocate to a business owner an amount of income in excess of $600,000 for joint return filers or $500,000 for single filers. So the maximum individual rate will not apply to most of the allocated income. As a result, the income tax rate differential between the individual rate the corporate rate may not be as great as the comparison of the maximum individual and corporate rates would suggest.
Pass-Through Income Deduction. The new tax act creates a new deduction for pass-through entities of up to 20% of qualified business income allocated to owners. This deduction lowers the effective income tax rate applicable to pass-through income allocated to individual to an amount closer to the new 21% corporate income tax rate. But the deduction for pass-through qualified business income is subject to several rules which can reduce or eliminate the deduction. The amount of the pass-through deduction generally cannot exceed the greater of: (a) 50% of wages; or (b) 25% of wages, plus 2.5% of the adjusted basis of depreciable property used in the business. The deduction also does not generally apply to certain specified services businesses. Therefore, the amount of income, the amount of wages, the amount of depreciable property and the nature of the business will affect the overall effective individual tax rate.
Double Taxation. Revenue generated by a C corporation is potentially subject to double taxation – once when received by the corporation (at the 21% corporate rate) and again when distributed to the shareholder (at the 20% qualified dividend rate). The shareholder would also potentially be subject to the 3.8% net investment income tax rate on the dividend. The combined double tax rate would likely be at least 41%, which would be comparable (or even higher) to the tax rate applicable to owners of an “S” corporation or other pass-through entity.
Lower Overall Tax Possible Where Dividend not Paid. If a C corporation does not want or need to distribute its after-tax income to shareholders then the tax rate on the income earned by the corporation would be limited to the 21% corporate rate. This situation would result when a corporation plans to use its revenue to pay down existing debt or accumulate money for future expansion. The 21% tax rate that would apply to the undistributed income and to the investment earnings on such monies would be lower than the ordinary income rate applicable for high-earning individuals.
Future Sale of Business. Another factor to consider is the tax consequences that would occur upon sale of the business. If the corporation intends to sell its assets in a relatively short time frame, then conversion of an S corporation to a C corporation is probably not advisable because it creates a double tax situation. But if a sale of the business is many years away, conversion from “S” status to “C” status for a period of 5 or more years, and then re-election of “S” status five (5) years before the sale might make sense.
Termination of “S” Election. There is no special IRS form that must be filed in order to revoke an S corporation election. Instead, the corporation files a written statement with the appropriate IRS service center. The statement must clearly state that the corporation is revoking its election to be an S corporation. This statement must include consent from shareholders who hold more than 50% of the outstanding shares of voting and non-voting stock of the corporation. Unless the revocation specifies an effective date, then the effective date depends on when the revocation is filed. If the revocation is made on or before the 15th day of the third month of the current tax year, the revocation is effective as of the start of the current tax year. If the statement is filed after that date, then the revocation is effective on the first day of the next tax year.
Please contact Jeff Senney at 937-223-1130 or Jsenney@pselaw.com to discuss conversion of an S corporation into a C corporation or any other federal or state income tax matter.