by Lance Christensen, Susan Jacobini Harrington, and James Graff, Partners at Margolin, Winer & Evens LLP
Is it time to make the switch from S-Corp to C-Corp status?
That’s a big question that closely held businesses currently treated as S-Corps are asking in light of the new tax law. Informally known as the Tax Cuts and Jobs Act (TCJA), the historic tax reform legislation – unrivaled in its scope since the 1986 Tax Reform Act – has radically slashed the corporate tax rate from 35 to 21 percent.
So shouldn’t the new corporate tax rate spur S-Corps to become C-Corps, too, especially when considering that pass-through owners, on average, will now be taxed at much higher rates?
The short answer is – not necessarily.
No Simple Tax Calculation.
Certainly, on the face of it, the argument appears compelling for S-Corps to switch, having previously shied away from such consideration given the onerous double tax that accompanied C-Corp status – at both the entity level, and secondly, upon distribution of dividends to shareholders.
Despite the new law’s relatively favorable corporate tax rate, however, a closer look reveals this is no simple tax calculation. In fact, in crunching the numbers, our research reveals that commercial enterprises, such as manufacturers, distributors, and service companies, may actually end up with a larger tax liability after switching to C-Corp status.
Every situation is unique, of course. Yet, in all cases, the switch to a C-Corp can have long-lasting
implications, and once done, generally cannot be reverted to S-Corp status for at least five years. Given that reality, it is imperative for S-Corp – along with other passthrough entities, such as limited liability companies and partnerships – to carefully consider the plusses and minuses of both scenarios.
Here are a few to consider.
Tax Implications of Your Business Location.
Let’s start with your S-Corp’s location. It is critical that you assess your effective state tax rate, not just your federal tax rate, if you were ever to switch to a C-Corp.
In addition, if your business operations are located overseas, repatriation provisions under the new tax law may make a switch to C-Corp status tax advantageous.
New Deductions for Qualified Business Income.
You may actually be better off remaining an S-Corp in order to take advantage of the new tax law’s 20 percent deduction for qualified business income. The operative word here, though, is qualified.
Whereas previous tax law provisions allowed for a much more narrow deduction for domestic manufacturers (9 percent), the new tax law offers a much broader deduction. Still, there are a number of cases where an S-Corp will not qualify – tax code section 199A, specifically, phases out companies like consulting firms, medical practices, and brokerage services, beyond certain taxable income thresholds.
Even among qualifying entities, the 20 percent deduction on qualified business income comes with stipulations, and you can never completely eliminate your income tax burden even if you qualify for a pass-through deduction. There are two key limitations to consider.
Most pass-throughs will be limited to 20 percent of ‘qualified business income” but may be cut back to 50 percent of W-2 payroll. While there’s an alternative limitation that could qualify you for more than the 50 percent, you’ll need to do two calculations in order to claim the maximum deduction at the pass-through level. The alternative limitation allows you to add 25 percent of W-2 income, plus 2.5 percent of unadjusted basis of qualifying property, then compare the tallied result to 50 percent of the W-2 – whichever is higher is the allowable deduction (limited to 20% of QBI).
A second limitation to the deduction comes in having to factor in the shareholders’ taxable income, less their capital gain income, multiplied by 20 percent. The ensuing number is then compared to the pass-through deduction, and if that taxable income number is lower, the shareholder can only take the lower number as a deduction.
Costs of Retaining Cash.
There’s another critical question to consider before making any switch. Has your business historically retained a lot of cash inside the business for expansion or other purposes?
If you’ve answered yes, you may be looking at far greater implications of retaining cash if you were to make the switch to a C-Corp. There have been many instances of C-Corps letting cash stack up indefinitely, as a way to avoid distributing dividends and thereby facing an onerous tax burden. In the event you’re thinking of making the switch to a C-Corp and doing the same, there are several pitfalls to consider.
If the IRS deems the accumulated cash excessive, and rules the cash should have been distributed as dividends instead, your C-Corp could face an accumulated earnings tax. This is essentially a penalty tax, a 20 percent surcharge, which stipulates you can only retain a specified amount of cash – in most cases, as a closely held business, for business operations.
Additionally, if your C-Corp is structured as a personal holding company, you may face the sizable headache of additional taxes, on top of the corporate tax rate, triggered by undistributed personal holdings company income.
These are just a few pitfalls that must be factored into the analysis, before rushing to make any switch. Also ask yourself: How long do you plan on holding your company? Is it for the long or short term? Those will be critical questions, too.
Looking Ahead.
If the massive, 1,097-page GOP tax bill proves anything, it’s that no business can rely on a simple calculation, nor “one-size-fits-all” approach, to drive its restructuring decision making.
The wisest thing you can do is to weigh all options, and seek professional tax guidance to ensure you understand all possible tax implications. Because the last thing you want is to make a decision you can’t undo, least of all for five years.
Lance Christensen is a partner at Margolin, Winer & Evens LLP serving in the tax department. Susan is a mergers and acquisitions expert with more than three decades of broad-based business and tax experience across diverse industries.
Susan Jacobini Harrington, CPA, partner at Margolin, Winer & Evens LLP, is a mergers and acquisitions expert with more than three decades of broad-based business and tax experience across diverse industries.
Partner at Margolin, Winer & Evens LLP, James Graff‘s practice includes providing auditing, tax, and management advisory services to clients in various industries, including real estate, professional services, manufacturing and distribution.
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