The recent Tax Cuts and Jobs Act created a significant benefit for C corporations. The corporate rate was reduced to a flat 21% vs. a maximum rate of 35% prior to 2018. This is great news for existing C corporations. For those entities that are currently S corporations, it begs the question of whether they should convert to C corporations to take advantage of these lower rates. The maximum rate for individuals was also reduced but only by a slight amount from 39.6% to 37%. The answer would appear to be straightforward but there are many items to be considered.
Some C corporations will actually pay higher taxes under the new law. This is because under the old law there was a graduated rate for the first 75,000 of taxable income. For example, a C corporation with $75,000 of taxable income paid $13,750 under the old law but will pay $15,750 ($75,000 x 21%) under the new law. The benefit of graduated rates started to phase out once taxable income exceeded $100,000.
C corporations are still subject to double taxation in that the entity itself is taxed and dividends to shareholders are also taxed. For example, under the new law if a C corporation was to dividend all its profits after paying its tax liability of $100,000 in taxable income, the resulting combined federal corporate and individual tax liability would be $39,802 or 39.8% ($21,000 in corporate taxes plus an additional $18,802 in individual taxes). Note that C corporation dividends are taxed at a maximum rate of 23.8%. On the other hand, the maximum rate for the shareholders of an S corporation would be 37%. For those taxpayers that are not in the maximum brackets, the difference is greater.
If a corporation did not dividend all of its profits after taxes, the liability would be reduced. In this case, the rate at 21% is much lower than a flow-through scenario but this is maybe for a temporary period of time until dividends are issued. The best scenario for a C corporation is when they have a business need to increase capital within the corporation, expect to declare very few dividends and ultimately expect to sell their stock in the corporation as an exit strategy. This depends upon the facts for each entity as to whether this strategy will work.
Another factor to consider is the new Section 199A deduction which may provide a deduction of up to 20% of qualified income. Using the above example, if an S corporation shareholder were to be taxed on $100,000 of flow-through income at the maximum individual rates and qualified for the 20% 199A deduction, their tax rate would be 29.6%. Note that there are several limitations on this deduction that might reduce or eliminate this benefit for certain taxpayers.
State taxes will also impact this decision. While state taxes are deductible for a C corporation, they are now limited for an individual. The itemized deduction on Schedule A for taxes is limited to $10,000 maximum for all taxes including income, property, and sales. This increases the effective cost of the state tax liability for a shareholder of a flow-through entity. This especially impacts those shareholders in high tax states.
These are just a few of the items to be considered when making this decision. As you can see, the answer is unique to each situation depending upon the facts and circumstances as well as the goals for the owners and the corporation. Please reach out to us if you have any questions for your particular situation.
This article is intended for educational purposes only and is not a substitute for obtaining competent accounting, tax, legal, or financial advice from a certified public accountant, attorney, or other business advisors. You should not act upon any of the information in this article without first seeking qualified professional guidance from your business advisors on your specific circumstances. The information presented should not be construed as advice or guidance from BFBA.