By Fred Sroka, Dean of the GGU School of Accounting & Bruce F. Braden School of Taxation
The tax rates for corporations have dramatically changed in 2018. The Tax Cuts and Jobs Act (TCJA) has reduced federal corporate tax rates from 35% to 21%. With this reduction, many flow-through businesses are asking whether they should convert to C corporations. Let’s explore the opportunity, and factors that may influence your decision.
The vast majority of U.S. businesses are organized as partnerships, limited liability companies (LLCs), or S corporations. These entities pay a single layer of tax on their income, while traditional corporations (called “C corporations”) pay two layers of tax, first at the corporate level (up to 35% federal) and second when the profits are distributed to the corporate owners (at up to 20% federal).
Choice of Entity in 2018: Three Key Questions
1. Can we convert to a C corporation for tax purposes?
Let’s begin with the simplest step, electing corporate status. Happily, the IRS has made this incredibly easy. Any LLC or partnership can convert to corporate status by filing form 8832. If the form is filed with IRS by March 15, the election can be effective retroactive to January 1, 2018! If your company is currently taxed as an S corporation, then you need to file a statement with IRS under Regs. §1.1362-6(a)(3) to terminate the S status and become a C corporation.
2. Will our taxes be lower as a C corporation?
It certainly sounds better to pay tax at the new 21% corporate tax rate than the 37% individual tax rate, even if your shareholders need to pay a second tax on any distributed profits. However, the decision is not that simple:
• Cost Recovery: Incorporating will only save taxes if the business generates profits. TCJA allows very liberal deductions for purchases of business property. You may be able to reduce or eliminate your company’s 2018 income by simply buying new business assets.
• Character: While many kinds of ordinary income is taxed to individuals at 37%, TCJA has dropped the tax rate on most business income to roughly 30% under new §199A. More importantly, capital gains are taxed to individuals at a 20% rate. If your business has substantial value in its trade name, goodwill and other capital assets, the decision to be taxed as a C corporation can lock current and future appreciation into double tax.
• State Tax: The double tax on corporations also applies to state taxes. If the owners plan on distributing profits from the business, they should be sure to consider the state taxes imposed on both the corporation and the shareholders.
• Basis: Tax basis is used to make sure that, at the end of the day, your cumulative taxable income or loss equals your cumulative economic gain or loss. If your tax basis in the business is less than total debt, the decision to incorporate can trigger immediate tax under §357(c). More importantly, corporations don’t allow owners to get basis in the entity’s debt. This prevents most businesses with substantial real estate (and related mortgages) from using corporate structures. Corporations also prevent the changes in basis due to transfers by owners from increasing the basis of company assets. In short, worry about incorporating any business that has a lot of debt or expects a lot of owner transfers.
3. Making the Decision to Incorporate
If your flow-through business is profitable, doesn’t have a lot of debt, doesn’t face a lot of state tax, and doesn’t expect many transfers, you may save substantial taxes by electing to be taxed as a C corporation. The benefits of incorporating are much higher if you plan to leave the profits in the business, since dividends from C corporations cause a second layer of federal and state tax. However, once you incorporate all current and future appreciation is locked into double tax, debt and transfers may cause increased tax burdens, and you can expect your state taxes to increase.
The vast majority of LLCs and S corporations will likely decide to retain their entity choice, benefiting from the newly reduced tax rates on flow-through business income. However, every business should consult with their tax adviser to see whether their tax structure fits the new environment of TCJA.
How to Learn More
The new tax law creates both challenges and opportunities for our alumni. If you advise clients, expect that planning for 2018 will add to the long hours already committed to the coming compliance busy season. If you’d like more resources, please feel free to email me. To build your skills, please also consider coming back for another course or two at GGU. We offer substantial tuition discounts to our alumni!