“Should I convert my business to a C corp?” We’re getting that question a lot, and, frankly, it used to be easier to answer. That’s because the passage of the Tax Cuts and Jobs Act (TCJA) changed the math. Under the new tax reform legislation, the corporate tax rate dropped from 35% to 21%, a full 14 points. At the same time, the top individual rate lowered just 2.6 points, from 39.6% to 37%. That’s a huge spread between corporate and individual tax rates that apply to pass-throughs and S corps. It’s no wonder people are wondering if now is the time to convert to C corp status.
What’s the answer? As always with taxes, it just depends.
First, know that it can be expensive. Accountants’ and attorneys’ time cost money. Ask yourself: “Will my tax savings be substantial enough to pay for my advisors’ time?”
Second, know that this is a long-term decision. You cannot easily flip-flop your entity status. Partnerships that make the switch effectively make a permanent decision and S corps that make the switch are precluded from reverting back for five years, at which point they are faced an additional 5-year period where they could face additional taxes for built-in gains on re-conversion. Instead of basing your decision on current tax rates, which could change at some point in the future, consider things like your exit strategy (how your tax entity status could affect issues like tax basis in the shares, sales price premium from the ability to sell assets, the small business stock exclusion, etc.), your business succession plan (how you’ll transfer ownership and yield the most tax savings), your after-tax liquidity needs, your ability to make new capital investments, the effect on equity compensation programs, the impact on new growth opportunities and your ability to generate a meaningful return on the tax savings you’ll see from converting, among other key questions about the future. Ask yourself: “Does converting align with my long-term strategy?”
Lastly, it can be time-consuming. Even if you are in a state that allows for “statuatory” (streamlined) conversions, the process of converting to a C corporation could be slowed by your need to file a set of articles of incorporation with the secretary of state's office; your need to draft a series of corporate bylaws; the election of corporate officers and directors; your need to hold annual board meetings and issue stock certificates; and so on. Ask yourself: “Are the savings worth the hassle?”
If, after answering those three basic questions, it’s looking like a good idea to proceed, we’ll help you answer even deeper questions like:
Will you pay out dividends?
C corporations face a layer of double taxation--once on the 21% corporate/preferential rate, and then the individual owner pays income tax on any dividends. The two levels of tax could make a corporate operation less advantageous than a partnership. If you don’t pay out dividends -- maybe you’ll reinvest profits back into the business as part of a long-term strategy -- then the C corp option may be right.
How will the new Section 199A deduction affect you?
The new Section 199A deduction, combined with other factors, could tip the scales in favor of remaining a pass-through, despite the reduction in the C corp tax rate. The TCJA creates a 20% deduction on income from certain pass-throughs. Assuming the full 199A deduction is available, the top rate for owners of a pass-through would be reduced from 37 to 29.6%. (Remember that the 199A deduction is only available to qualified trades or businesses, with many specific types of service businesses excluded unless income falls under certain thresholds, and is limited by the amount of wages or property invested in the business unless income falls under certain thresholds.)
How will state taxes affect your overall tax bill? The TCJA limits your ability to deduct state and local income taxes on your individual return but allows them to be deducted on corporate returns. How these taxes are calculated and paid differ between C corporations and pass-throughs though. Determining the overall tax impact of state and local taxes at both the corporate and individual level should play a key role in any decision concerning ownership status.
A thorough analysis of your unique situation and goals is the only way to make the decision to convert to a C corp. And, perhaps, we may find that breaking into two separate businesses makes sense (perhaps you do consulting work on the side which does not qualify for the pass-through deduction). Whatever your situation, we can help you make the right decisions to maneuver the new tax law and save you the most money. Don’t hesitate to reach out.