One of the questions that keeps popping up from my business owner clients is… Should I change my entity to be a C-Corporation? This question has been brought on by the recent passing of the 2017 Tax Act (i.e. the Tax Cuts and Jobs Act of 2017). One of the provisions of the 2017 Tax Act reduced the tax rate on C-Corporations from a top rate of 35% to a flat rate of 21%. Income from pass through entities such as S-Corporations, partnerships and limited liability companies continue to flow through to the tax return of the owner or owners where they will be taxed at the individual’s tax rate. The top individual rate is 37% (down from 39.6%). In addition, C-Corporations can fully deduct state and local taxes whereas an individual’s deduction is limited to a maximum of $10,000.
The short answer to this question is… maybe. While a tax rate of 21% is substantially lower than a tax rate of 37%, it is important to note that C-Corporations are subject to two levels of taxation, one at the corporate level on earnings (this is what the new 21% rate applies to) and one at the shareholder level, for example, on dividends. Qualified dividends are generally taxed at the rate of 15% to 20%, although there is usually no preferential tax rate at the state and local level. Dividends also may be subject to the 3.8% net investment income tax. If C-Corporation profits are distributed, the net effect of the double taxation can cause the total tax rate to exceed 37%. If a business does not make distributions to its owners (for example, the owners generally take only salary and profits are reinvested in the company), then a C-Corporation structure may result in income tax savings. On the other hand, if the business distributes all of its profit out to its owners annually, then the double tax resulting from a C-Corporation structure will most likely be disadvantageous.
Tax rates are not the only thing to consider when deciding on what type of entity is best. Income from pass-through entities may now be eligible for a 20% deduction on qualified business income. The rules around the qualified business income deduction are complex and there are several limits and exceptions which could reduce or eliminate this deduction.
Several non-tax factors also come into play in determining whether to change to a C-Corporation. For example, C-Corporations can be more complex to operate than pass-through entities and require considerably more legal compliance and paperwork. In addition, tax laws can change again in the future. It is important to know the implications of converting back to a pass through entity. If you are planning to sell the business in the near future you need to consider the implications of being a C-Corporation at the time of a sale.
While the above discussion highlights several important factors to consider in determining what type of entity to choose, it is by no means an exhaustive list. Each situation is different and it is extremely important that you review your own personal situation with your tax advisor before making any decisions.