C Corporation or S Corporation?
Five questions to ask in evaluating choice of entity following tax reform
September 2018 Footnote
We are faced with choices every day in our personal and professional lives. Most are relatively easy. The tricky part is when choices seem easy on the surface, but actually require careful analysis and planning.
Tax reform through the Tax Cuts and Jobs Act includes several provisions that changed the tax treatment of business income, including a new 20-percent deduction on qualified pass-through business income and a permanent reduction of the corporate income tax rate from 35 percent to 21 percent, among other changes. While C Corporation status became relatively more attractive as a result of tax reform, there is no one-size-fits-all approach to entity selection.
A C Corporation's earnings are subject to an entity-level tax and a shareholder-level tax when the earnings are eventually distributed to the shareholders, either in the form of dividends or capital gains from the sale or liquidation of the corporation. A pass-through entity's earnings, on the other hand, are generally not subject to an entity-level tax. Instead, the earnings pass through on Schedule K-1 and are reported on the owner's personal income tax return. The owner gets additional basis for the pass-through income. Distributions can be applied against basis without causing the shareholder to recognize income. The benefit of the single level of tax in a pass-through entity needs to be weighed against the possibility of a higher current cash tax cost associated with using a pass-through.
These five questions will help with the analysis.
1. What is the effective tax rate on business income?
A discussion of the Section 199A deduction and related limitations is beyond the scope of this article, but determining whether the deduction is available is critical in estimating the effective tax rate of a pass-through business. Once it has been determined whether the Section 199A deduction is available, the next step is to compare the effective tax rate on business income if the business operates as a C Corporation to the rate as a pass-through entity. The analysis should consider any available loss or credit carryovers.
When evaluating choice of entity, it is tempting to compare the top marginal federal income tax rates of a C Corporation and pass-through entity -- 21 percent for a C Corporation versus 29.6 percent for a pass-through entity eligible for the Section 199A deduction. While the corporate tax rate is a flat 21 percent, individual income tax rates are graduated, so it would be appropriate to compare the expected effective tax rate applicable to business income rather than the top marginal tax rate. As long as the taxpayer's taxable income -- without taking into account the business income -- is less than $500,000 ($600,000 in the case of a joint return), the effective tax rate will be less than 29.6 percent.
Example: A married couple has $190,000 of taxable wages, $435,000 of S Corporation business income (all of which is eligible for the Section 199A deduction), and no other items or income, deduction or credit; the couple's U.S. federal income tax liability is $131,279 if the business is an S Corporation, or $28,419 if the business is a C Corporation. The effective tax rate on the business income as an S Corporation is 23.6 percent ($102,860 incremental tax liability divided from $435,000 of business income).
In some instances, the effective rate will actually be less than 21 percent.
2. What do you expect income tax rates to be in the future?
The 21-percent corporate income tax does not expire. The reduced individual rates and the Section 199A deduction are set to expire after 2025. Regardless, it is possible that Congress will subsequently change the corporate tax rate or extend the individual tax cuts. No one has a crystal ball, but it is important to consider the effect of future tax rate changes on the choice of entity decision; it is easier to convert to C Corporation status than to convert from C Corporation status.
3. What are the short- and long-term plans for distributions to owners?
Businesses with significant income may have lower current cash tax expense as a C Corporation than as a pass-through entity. However, corporate earnings will become subject to a second level of tax as a C Corporation when the earnings are distributed. The second level of tax is important to consider when evaluating the tax consequences of the choice of business entity. All other things being equal, short- and long-term plans to reinvest earnings in the business will generally favor C Corporation status.
4. Would earnings retained in a C Corporation be subject to the accumulated earnings tax?
If a C Corporation retains earnings beyond the corporation's reasonable business needs, the IRS can impose a 20-percent accumulated earnings tax on the excess. Reasonable business needs may include debt retirement, business expansion, acquisition of another business and working capital, among others. The tax has been assessed infrequently because many corporations minimize corporate taxable income to avoid double taxation (rather than accumulating earnings). This is likely to change in response to the new, lower tax rates.
The tax is in addition to the corporate-level income tax and the shareholder-level tax that will eventually be imposed when earnings are distributed and, thus, results in triple taxation of corporate earnings. The tax does not apply to pass-through entities. If the tax would apply, the corporation would be better off either operating as a pass-through entity or distributing earnings to avoid the tax.
5. How and when do the owners plan to transition ownership of the business?
A business can be transferred in one of two ways: The assets can be sold with the proceeds distributed to owners in liquidation of the business, or the stock can be sold. Internal sales are more likely to be stock sales whereas sales to outside parties are more likely to be asset sales.
In a stock sale, the shareholders recognize gain or loss equal to the difference between their sales proceeds and their basis in the stock. S Corporation shareholders increase their stock basis for their share of undistributed earnings, which favors using an S Corporation, all other things being equal. In some instances, the shareholder-level gain from the sale or liquidation of a C Corporation is excluded from tax under section 1202, which favors using a C Corporation.
In an asset sale involving a C Corporation, a corporate-level tax applies to the asset sale and a shareholder-level tax generally applies when the corporation liquidates or distributes the proceeds. In some instances, the shareholder-level gain may be excluded under section 1202. If assets of a pass-through entity are sold, only one level of tax applies, generally favoring use of a pass-through entity.
If the business will be held until the owner's death, the heirs will generally have a fair market value basis in the stock, permitting the heirs to sell the business interests without recognizing gain or loss if the sale occurs at the time of death.
Play the odds by planning
Like other aspects of business planning, entity structure planning occurs in an environment of uncertainty. While only time will tell whether the selected tax structure for a business was the best one, careful planning and consideration of the discussed questions will improve the odds of selecting a structure that meets the needs of the business and its owners.
John Werlhof, CPA is a principal in CliftonLarsonAllen LLP's National Tax Office and is an instructor of the upcoming Tax Reform Deep-Dive Series webinars and the Tax Advisers Update seminars for the MNCPA.