The Key Benefits To Remaining An S Corporation

Is Remaining an S Corporation the Right Move For Your Business?

“To be or not to be, that is the question.” Is it better to stay as an S Corporation or make the switch to a C Corporation?

The Tax Cuts and Jobs Act (TCJA) has made the consideration to switch to a C Corporation more compelling given certain facts. The new C Corporation’s tax rate is now at a flat 21 percent, so on the surface the C Corporation seems more attractive for many closely held businesses that are very profitable.

However, there are many other items to consider. The following breaks down elements of each.

C Corporation

  • The tax basis in a C Corporation does not change based on the annual activity of the company. If a C Corporation makes $1,000,000 it has federal tax to pay of $210,000 with $790,000 of net after tax profits left in the business.
  • The outside shareholders wanting additional income from the business could be paid a dividend out of the net—after tax profits of $790,000. The dividend paid to the C Corporation shareholders would be taxed at a rate of 23.8 percent or possibly lower.
  • The C Corporation and its shareholders are subject to double taxation— once at the C Corporation level and the second at the shareholder level for the dividends paid to them. The C Corporation owners personal tax basis in the company does not change, that is to say, their tax basis is still their stock purchase price or inherited basis.

S Corporation

  • Taxes are paid by their shareholder owners. The highest federal individual rate is 37 percent. The Qualified Business Income (QBI) should be calculated to help lower taxes for the S Corporation shareholders.
  • QBI creates a ‘below the line’ tax deduction for pass-through entities and sole proprietorships subject to certain limitations. The QBI deduction can reduce the effective tax rate to 29.6 percent.

The QBI deduction is limited to the lesser of:

  • 20 percent of the taxpayers QBI or;

The greater of:

  • 50 percent of the W-2 wages with respect to the business, or
  • 25 percent of the W-2 wages with respect to the business plus 2.5 percent of the unadjusted basis of all qualified property

Specified Service Businesses

S Corporation:

  • These businesses, such as health, law, accounting, performing arts, financial services, athletics, and consulting services have very limited benefit with these rules. There are income limits to QBI.
  • If an S Corporation made $1,000,000 then its shareholders would have to pay tax at 29.6 percent effective tax rate. This assumes no limitations.
  • The company would distribute $296,000 to tax shareholders to cover their tax— $704,000 of the after tax profit remains in the business.
  • The amount left in the business increases the shareholders tax basis in the S Corporation. Contrast this to the C Corporation scenario above.
  • If the shareholder wanted additional cash out of the business then a maximum of $704,000 could be distributed to them tax free. For every dollar distributed the S Corporation shareholder tax basis decreases.

Effective Rate Comparison Chart

C CorpPass-through
Income Tax Rate21%29.6% (effective)*
Dividend/Exit Tax Rate20% + 3.8% = 23.8%0%
Aggregate Tax Rate44.8%29.6%
State and Local Tax100%Property taxes deductible, SALT income taxes not deductible
Tax Basis Adjustment (Yearly Activity)NoneTax basis increases by net after tax earnings less tax distributions.

*Assumes no 3.8% tax applicable and full use of 20% pass-through deduction

 

Established Businesses with Several Years of High Profit

  • As a C Corporation with every paid out dividend the shareholders must pay a maximum tax of 23.8 percent.
  • If the company is recapitalized, or borrows funds to pay out a large dividend, this dividend would be subject to tax of 23.8 percent. If the stock of the C Corporation is sold, the gain would be measured from the proceeds received for their stock versus the tax basis in the stock.
  • Remember as a C Corporation your tax basis in the stock does not change based on the yearly activity of the company.
  • If the company is sold on an “asset deal” basis there is an initial tax to be paid at the company level as a C Corporation and a second level of tax for the net amount distributed to the shareholders.
  • An S Corporation sold as a stock deal would have its shareholders pay tax on the gain as the difference from proceeds received and their tax basis in their stock. However, the S Corporation shareholders basis has increased for the cumulative earnings not distributed. This could be a significant difference in tax paid at sale.
  • The impact is further amplified when the S Corporation is sold in an “asset deal”. The S Corporation does not pay a separate tax, but rather there is one level of tax to pay at the shareholder level. No double taxation!

For many items addressed under the TCJA, there is no difference between a C or S Corporation, Section 179 expensing, immediate deduction for cost recovery of qualified business assets, cash basis accounting treatment, limitation on the deduction of business interest, and others.

The decision to stay an S Corporation is strong, indeed, depending on your specific business goals.

Our tax advisors are happy to sit down and discuss your businesses needs to evaluate what would be best for you.

 

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