It’s the beginning of the new year and it’s about that time to start thinking about your taxes again. Of course, completing your 2017 taxes by April are most likely the #1 thing on your mind. #1a should be figuring out how to take advantage of the new tax reform. There are many key changes to both the business and individual tax structure that have been implemented by the new tax legislation. This week I wanted to focus on a topic that many small business owners may have been contemplating as soon as the first draft of the new tax reform rolled out last year – converting their company to a C Corporation.
This seemed like the natural move since C Corporations were going to get a favorable tax rate moving forward (the actual rate ended up being a flat 21%). While this may seem like a logical thing to do, there are many positive and negative factors to consider. Let’s delve into some of the negative considerations so you are fully aware of the potential impact of a conversion to a C Corporation. Note this is not an all-inclusive list of factors as facts and circumstances dictate each business owners’ decision process.
In a pass-through, profit distributions are tax free if there is enough tax or stock basis to take them (i.e. prior net earnings plus capital contributed less profit distributions taken). Once this is exceeded, the distributions in excess of tax or stock basis are generally taxed at capital gains rates.
In a C Corporation structure, profit distributions of accumulated earnings and profits (AE&P) are generally taxed at 15% (but can be as high as 23.8% depending on your individual AGI). When you hear someone talk about “double-taxation” of C Corporations, this is what they are referring to. Additionally, once AE&P is reduced to zero by profit distributions, then future profit distributions are tax free up to the amount capital infused into the company. After this, they are taxed at capital gains rates.
Future Sale of Your Business
Depending on how the sale is structured, there may be a tax on the sale of the business to your C Corporation and then a second tax on the shareholders’ distribution of net proceeds. Again, potential double taxation.
The Tax Rate Game and Reasonable Salary
Active shareholders in a corporate entity (C and S Corporations) are required by the IRS take a “reasonable salary”. This salary reduces corporate profits and is considered compensation/wage income to the recipient on his or her personal taxes. For C Corporations, the net amount is taxed to the company. For S Corporations, the net amount flows through to the owners’ personal taxes and is added to other income earned personally earned. This, in turn, is then reduced by itemized deductions to come to a taxable income figure.
At the personal tax level, the net taxable income is taxed in brackets. So, what does this mean? Even though your total taxable income may be in, say the new 24% bracket, your total tax won’t be your taxable income times 24%. Each “layer” of income in the brackets is taxed at a different rate. Once you figure out your personal effective tax rate, this figure should then be compared to the C Corporation tax rate of 21%. In some cases, it may be more beneficial to keep a pass-through structure as your effective rate may be less than the corporate rate. This takes a careful, detailed analysis to determine but everyone with a business needs to run this calculation this year.
In some cases, converting your business to a C Corporation can result in an unintended taxable gain, even without an exchange of cash. An example of this is when a LLC with negative equity (liabilities exceed assets) converts to a C Corporation. The IRS views this as a taxable gain that is reportable in the year of conversion.
State Tax Considerations
As most are well aware, the owners of a pass-through entity generally pay Federal and state taxes on business profits along with their personal taxes only. C Corporations pay Federal and state taxes on business profits at the entity level. Business owners need to compare state tax rates for their personal taxes versus what the state would charge for a Corporation. An example of a significant difference is with Pennsylvania. Pennsylvania personal income tax rates are 3.07% while corporate rates are 9.99%.
Another thing to consider is that state and local taxes are limited to $10,000 with your personal taxes starting 2018. Corporate taxes have no limit to deduct against income.
As you can see there are many considerations to think about. On top of those mentioned above, if you have a LLC with multiple owners, you are able to specially allocate income and losses depending on the economic circumstances of your operations. For C Corporations, there is generally no option to do this. Additionally, there will most likely be some legal costs to amend and/or file new incorporation documents for your business.
As you can see, immediately converting your business to a C Corporation starting 2018 should probably not happen. We recommend all business owners take the time to discuss the implications of converting to a C Corporation with their tax advisors before tax season kicks into high gear. It may even make sense to keep your current structure and create a separate C Corporation that is an affiliate of the business. This is beyond the scope of this article, but be sure to bring this topic up with your tax advisor.
If you have any questions about the new tax law effect on your business or if you would like a C Corporation analysis completed, please reach out to me directly!