In the wake of the recent tax reform legislation, many business owners are reevaluating the structure of their organization and questioning whether it would be beneficial to convert from a C corporation to an S corporation, or vice versa. The following is a review of the two structures and a breakdown of the changes brought on by the tax code overhaul.
Background on C Corporation and S Corporations
A C corporation (“C corp”) is simply a standard corporation and is the most common type of corporation in the United States. An S corporation (“S corp”) is a corporation that has elected a special tax status with the IRS. C corps and S corps chare the following characteristics:
- Limited liability protection
- Definition as a separate legal entity
- Establishment via filing of Article of Incorporation
- Corporate structure made up of shareholders, directors, and officers
The IRS considers C corps separate taxable entities; C corps are required to file a corporate tax return and pay corporate taxes. Additionally, C corps are subject to “double taxation.” This phrase describes the situation when corporate income (which has already been taxed) is distributed to business owners as dividends, then those dividends (which are considered personal income) are taxed on the individual level.
S corps, on the other hand, are pass-through tax entities. Through they are required to file an informational federal return, they do not pay out any corporate income tax. Rather, the S corp’s profits, or losses, are reported on the personal tax returns of the business owners and any tax that is due is paid at the individual level.
The Tax Cuts and Jobs Act of 2017 includes several major changes to the tax laws affecting corporations.
For C corps:
- Income tax was lowered from a maximum rate of 35% to a flat 21%,
- Corporate alternative minimum tax was repealed, which results in simplified tax reporting for many corporations,
- State income tax deduction was preserved, and
- “Double taxation” was preserved—C corp dividends remain subject to the maximum 20% qualified dividend rate.
For S corps:
- Income tax dropped from a maximum rate of 39.6% to 37%,
- Individual alternative minimum tax was preserved but now phases in at a higher level,
- Individual deductions for state and local taxes are now capped at a combined $10,000, and
- Pass-through income that meets the requirements of qualified business income (QBI) is eligible for a 20% deduction (this is currently set to expire for tax years beginning after 2025).
Many business owners are facing big questions and big decisions. As an S corp, should we change out tax structure from a pass-through to a C corp in order to take advantage of the 21% flat tax? Should we transition our C corp to an S corp in order to reduce our taxes through access to the QBI deduction?
Though it may seem advantageous to restructure your organization, there are a vast number of elements that must be considered before making a structure switch. Be sure to consult with your Blackman & Sloop tax advisor to determine the best course for your unique situation.