That question can be especially difficult now for closely-held, usually family businesses that are often structured as S corporations. These entities, along with other pass-throughs such as limited liability companies and partnerships, flow their income through to their investors, who pay the tax.
Because of the tax rate cut to 21 percent for C corporations under the 2017 Tax Reform and Jobs Act, businesses are considering whether their present corporate structures make the most sense. The new tax law changes the effective tax rate for many companies—depending on industry, kind of structure, and location.
S corporation owners should now begin to model out how the new tax law will affect their businesses. The new law changes are significant enough for every business to take a look at what makes the most sense for them, and whether their business should convert to (or remain) a C corporation. Rothberg Logan & Warsco can help you with this review and analysis. Here are some things to question as the new tax law takes effect.
Determine the S Corporation Effective Tax Rate: How Much Income Qualifies for 20 Percent Deduction?
The new tax law provides a 20 percent deduction for pass-through entities, including S corporations. But the tax break phases out for service companies like medical practices and consulting firms beyond certain taxable income levels—$157,500 for individuals, $315,000 for joint filers. The deduction is also limited by how much the company pays in wages to employees.
Knowing how much income will be subject to the deduction is critical to determining whether it is advantageous to be an S corporation. If one just assumed that all S corporation shareholders would be subject to the maximum rates of tax and assume all their income is eligible for 20 percent deduction, it is fair to say it is advantageous to be operating as an S corporation.
But many companies will find that the deduction is more limited, either because not all their income is considered to be qualifying business income or because they do not pay enough in wages. Companies need to analyze their specific circumstances and compute what their effective tax rate will be.
Next: Compare C and S Corporation Rates
Once an S corporation knows what its effective tax rate likely will be, it should then compare it with the new effective tax rates for C corporations. Rothberg can help you with computing your effective tax rate and comparing that with the effective rates you would incur if your business operated as a C corporation. But the analysis does not end there.
Other Determining Factors
Companies also need to think about how much of their earnings they plan to distribute to their shareholders. While corporations will pay a 21 percent income tax rate—and pass-through owners will pay about 29.6 percent, depending on their tax bracket and the type of income—corporate distributions will still be taxed. The biggest determinant as to whether you should go to C status is how much of the profits you expect to distribute as dividends. If you are going to distribute all the profits as dividends as a C corporation, your tax rate is going to be higher than if you are a pass-through S corporation.
Also, owners considering moving to a corporate structure should be aware of the accumulated earnings tax, a 20 percent tax on companies holding on to too much cash, and the personal holding company tax, another 20 percent penalty on undistributed passive income earned in a closely-held C corporation.
Further, companies should also consider whether they expect losses in the future. If you stay a pass-through, those losses can flow through to the owners and offset other types of income.
Are there plans to sell or acquire another company? If there are any plans to sell the company in the near future, it makes sense to stay an S corporation because it is much easier to sell a company with a single layer of tax. Asset sales, as opposed to stock sales, are particularly attractive for S corporations looking to sell or to buy another company. Buying the assets allows the owners to depreciate the property, which is even more beneficial under the new tax law, which expands expensing provisions.
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