With the corporate tax rate going from 35% to 21% in 2018, several business owners are wondering if they should change their pass through entity to a C-Corp. In short, for many small business owners, choosing C-Corp status is not a viable option.
There are some exceptions where choosing C-Corp status might be beneficial but for the vast majority of tax filers, a pass through entity is still the go-to route. This article will breakdown exactly why changing to a C-Corp still isn’t a good idea even with the top corporate rate decreasing.
The Allure of C-Corp Status
You’ve probably been skimming through articles online, listening to soundbites on TV, or hearing chatter among your peers or colleagues: “The C-Corp is making a come back,” they say.
The top corporate tax rate is changing from 35% to 21% while the top rate for individuals is only going down 39.6% to 37%. You’re probably thinking to yourself, that top rate of 21% sounds a lot better than 37%.
It’s no wonder why business owners all across the country are thinking about changing the structure of their business.
One of the major drawbacks of a C-Corp is double taxation. For most pass-through entities, income is reported at the entity level and then passed through to the owner’s individual tax returns. So if your partnership reported taxable income of $100,000 and you share 50% of that profit, then you will report $50,000 on your individual income tax return – regardless if the money was distributed to the owners.
For C-Corporations, income is reported and taxed at the entity level. So if the C-Corp made $100,000 for the year then it would pay tax on that $100,000. Once the money is distributed to the owners then the owners would also report taxable income on their individual income tax returns.
For taxpayers who live at the top of the tax brackets and who distribute most of their income from their business, the C-Corp doesn’t make much sense. The entity pays a 21% flat tax rate and any dividends paid would be taxed at the top qualified dividends rate of 20%. In total, the rate looks more like 41% than 21%.
What About Small Business Owners?
What if you don’t earn that much income from your business but you make a cool six figures per year? The qualified dividends rate is 0% on the first $38,600 for individuals and 15% after that (until you hit $425,800). So if the business only makes $100,000 per year, why not switch over to a C-Corp?
Again, double taxation. That $100,000 is going to be taxed at a flat rate of 21% while the effective individual tax rates would be much lower. Additional tax would be paid on amounts over $38,600 which would make the situation worse.
What If I Want to Sell My Business?
Selling a business that is a C-Corp gets a little more complicated than an S-Corp. For the most part, investors looking to buy small to medium-sized businesses don’t want to buy corporate stock. There are liabilities and possibly outstanding lawsuits that they might not be aware of. Investors would much rather buy the assets of the business and leave the business owner with all the liability.
For a subchapter S-Corp the profits from an asset purchase agreement or a sale of stock would flow through to the owner. This means they would pick up tax only once.
For the sale of C-Corp stock, the owner will pickup capital gains/losses. But as mentioned before, investors don’t want to buy your stock, they just want the assets. If the business is sold via an asset purchase agreement then the C-Corp will pay capital gains tax and then the owners will pay additional tax on the distribution.
Therefore, for small to medium-sized businesses who are considering selling their business anytime soon, it might be better to stick with the pass-through status.
When is Switching to a C-Corp Beneficial?
There are scenarios where it might be beneficial to switch to a C-Corp status. This has less to do with tax and more to do with overall business structure.
- If you want foreign investors then switching from a S-Corp to a C-Corp is necessary.
- If you have more than 100 stockholders then you’ll chose a C-Corp over an S-Corp because S-Corps limit the amount of stockholders to 100.
- If you don’t distribute much income from your business you don’t have to worry about double taxation if the money stays inside the company.
#1 Rule Before Making the Switch
Before you make the switch from a pass-through entity to a C-Corp you want to discuss with a tax advisor. It’s easy to switch from a S-Corp to a C-Corp but it’s not easy-going back which is why it’s important to seek professional advice before making the leap into a C-Corp.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer. Photo Copyright: <a href='https://www.123rf.com/profile_logo3in1'>logo3in1 / 123RF Stock Photo