Carissa A. Conley, CPA
With the newly lowered corporate tax rate, many pass-through businesses are wondering if they should now convert to a C Corporation. The Tax Cuts and Jobs Act (TCJA) reduced the corporate tax rate from a maximum of 35 percent to a flat rate of 21 percent and eliminated the corporate AMT.
Meanwhile, income of pass-through entities is taxed at the individual taxpayer level which is still based on graduated rates up to a maximum of 37 percent. While this initially sounds like a no-brainer, in most cases, small businesses will be still pay less tax as a pass-through entity.
Even though a C Corporation is only taxed on its net income at a rate of 21 percent now, there is still the issue of double taxation when shareholders take dividend distributions. Depending on the shareholder’s tax bracket, these dividends which have already been taxed at 21 percent, are now taxed again at a rate up to 20 percent (for those in the highest tax bracket) plus another 3.8 percent for Net Investment Income tax.
This brings the effective tax rate on dividends to 39.8 percent, which is higher than the maximum individual tax rate of 37 percent. Note that this is only considering the federal tax and there would be additional tax at the state level for both the corporation and the shareholder.
The TCJA also added a new deduction for pass-through entities which provides a 20 percent deduction for qualified income earned by a qualified business. There are a number of restrictions and limitations with this deduction but if your business income does qualify, this reduces the maximum individual effective tax rate to 29.6 percent, which is almost 10 points lower than the tax rate on combined earnings and dividends of a C Corporation.
If you’re still not sold and think you would benefit tax-wise from operating as a C Corporation, consider the tax disadvantages of selling the C Corporation down the road. It will be in your best interest to sell the stock of your company because the gain will be considered a long-term capital gain and will be taxed at preferential tax rates. But the buyer will likely only want to buy the assets for a number of reasons.
First of all, the buyer does not want to inherit all known and unknown liabilities of the Corporation. Additionally, if the buyer purchases only the assets, the buyer gets to step up the basis of the assets and benefits from larger depreciation deductions than if they inherited the assets that have already been partially or fully depreciated by the Corporation.
When you sell the C Corporation in an asset sale, any gain on the assets is treated as ordinary income to the C Corporation.
Tax will be paid on income at the C Corporation level and then again at the shareholder level when you distribute the remaining proceeds to the shareholders. That brings us back to the double taxation issue which we’ve already shown to create a higher tax rate than income generated by pass-through entities.
There are reasons to convert to a C Corporation but a reduction in tax liability is not one of them.
Conley is a senior tax manager with CMJ, LLP.