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Is a C-Corp. Conversion Right for Your Business?
With the steep reduction in the federal corporate tax rate under the Tax Cuts and Jobs Act (the “Act”) recently signed into law, many businesses that operate as tax pass-throughs, such as partnerships, LLCs or S-Corporations (“S-Corp.”), may be considering converting to C-Corporation (“C-Corp.”) status instead.
Under the Act:
- The top federal rate for individuals is reduced from 39.6% to 37% tax on ordinary income such as wages, dividends that are not qualified dividends and short-term capital gains (gains on investment assets held for less than one year). This tax rate will return to 39.6% after 2025 unless the reduced rate is extended or made permanent by subsequent legislation.
- Net investment income continues to be taxed at 3.8%, which is in addition to the top rate of 37%, on any investment income for married couples with gross incomes over $250,000 filing jointly and for individuals with gross incomes over $200,000.
- The federal corporate tax rate drops from 35% to 21%.
No doubt, the drop in the corporate tax rate to 21%, together with the fact that C-Corps. can continue to deduct state and local taxes (SALT) beyond the $10,000 cap for individuals, makes a conversion to a C Corp. look very attractive. However, companies should think carefully before making any changes to their business structures that could be expensive to unwind. Some things to consider:
- If your company plans to distribute all profits as dividends of a C-Corp., the effective tax cost will be higher to investors than if the business is a pass-through.
- Typically, dividends are taxed to an individual recipient at the qualified dividend rate of 20%, though there is usually no preferential tax rate at the state and local level. Dividends may also be subject to the 3.8% net investment income tax mentioned above. Taking into account only federal taxes, the effective double tax rate (combining the corporate and individual rates) is 39.8% on earnings distributed as dividends.
Generally, members of pass-through entities under the Act receive a 20% deduction on qualified business income (“QBI”), which is then taxed at the individual rate (more on what that means in a moment). After accounting for the deduction, but before social security and Medicare tax, high-earning pass-through owners paying the top 37% rate have an effective rate of 29.6%.
If a business does not make distributions to its owners and reinvests its profits (excluding salary and perks) then a C-Corp. 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-Corp. structure will be disadvantageous. In between these extremes, the benefits of one structure over another can be determined mathematically.
The Act provides an additional benefit of the 20% deduction on QBI. However, the definition of QBI limits or restricts the 20% deduction based on the wages the entity pays, the amount of equipment the entity purchases, and how much the owner earns. It is important to note that the 20% QBI deduction is totally lost once the partner’s taxable income equals $415,000 ($207,500 if not married filing jointly). The availability of the 20% deduction is further limited as it specifically excludes many service businesses from the tax break. This means that the business owner must look at a number of factors before deciding whether a C Corp. offers the best option from a tax point of view.
Each case will be fact-dependent when deciding if switching to a C-Corp. is right for your business. Partnerships, LLCs and S-Corps., particularly those that won’t see much benefit from the QBI deduction, should seek professional advice before electing to be taxed as a C-Corp. According to the Tax Policy Center, almost 90% of pass-through businesses already pay a tax rate of less than 25%, the cap in the new bill. Only those individuals with tax rates above the new 24% rate ($157,500 for single filers and $315,000 for married filing jointly) would pay the 25% rate. At the same time, it must be understood that the costs associated with being a C-Corp. can be significant, and the savings derived from the 21% tax rate may not cover those costs.
Bottom line, only a small group of businesses will derive enough upside from converting to a C-Corp. to offset the double tax hit that occurs from a distribution to shareholders. Such businesses will have the following attributes:
- Generate a large amount of income;
- Reinvest heavily in its business;
- Intend to keep cash within the business for some substantial amount of time; and
- Pay substantial state and local taxes (which remain deductible for C-Corps. but are capped for individuals).
The best advice is to consult with your tax advisor or attorney who can weigh the benefits of your business’s structure. For more information on this topic or for assistance, please feel free to contact the corporate and tax specialists at Michelman & Robinson, LLP: Michael Poster (firstname.lastname@example.org), Ian Shane (email@example.com), Eric Simonson (firstname.lastname@example.org) or Peter Cifichiello (email@example.com).
This blog post is not offered as, and should not be relied on as, legal advice. You should consult an attorney for advice in specific situations.