TCJA and Corporate Tax Structure
One year after the enactment of the 2017 tax legislation commonly known as the Tax Cuts and Jobs Act (TCJA), taxpayers continue to reconsider their historic choice of entity for federal income tax purposes.
The significant reduction in the corporate tax rate (from 35% to 21%) brought about by the TCJA has many S corporations and partnerships considering whether to convert to a C corporation to take advantage of the lower rate. Before electing to make the change, taxpayers should understand the many ramifications of converting. The IRS released Rev. Proc. 2018-44, which modifies Rev. Proc. 2018-31, to reflect the statutory amendments made by the TCJA relating to the revocation of an S election.
S Corporation Revocation
S corporation status may be terminated by revocation only if shareholders holding more than one-half of the shares of stock of the corporation on the day on which the revocation is made consent to the revocation (Sec. 1362(d)). Rev. Proc. 2018-44 discusses how certain S corporations that change from the cash method of accounting to the accrual method of accounting due to a revocation of their S election either must or can elect to take into account positive or negative Sec. 481(a) adjustments for the change over a six-year period.
To be eligible, the company must: (1) have been an S corporation on Dec. 21, 2017; (2) have had the same owners of stock, in identical proportions, on Dec. 22, 2017; (3) have the same owners of stock, in identical proportions, on the date of revocation; and (4) elect to revoke S corporation status after Dec. 21, 2017, and before Dec. 22, 2019.
An S corporation that converts to a C corporation is generally required to change from the cash method of accounting to the accrual method of accounting. However, a terminated S corporation may remain a cash-basis taxpayer if its average gross receipts for the three previous tax periods are less than $25 million.
Key Considerations for Pass-Through Business Taxpayers
Considering whether to convert requires decisions about both short- and long-term business goals, growth expectations, owner exit timing, distributions, and estate tax planning. Below are a few of the items that should be considered.
New Qualified Business Income Deduction
This new deduction allowing pass-through business owners to claim a deduction for up to 20 percent of their allocable “qualified business income” brings the individual income tax rate somewhat closer to the new corporate income tax rate. (Section 199A(a).)
For an individual paying the new top federal individual income tax rate of 37 percent, this deduction is equivalent to a marginal income tax rate decrease of 7.4 percent to 29.6 percent (20% x 37% = 7.4%; 37% - 7.4% = 29.6%).
However, many pass-through businesses may not qualify for this new deduction, both because of the carve-out for “specified service trades or businesses” and because of the wage and property basis limitations.
Furthermore, 29.6 percent is still 8.6 percent higher than the 21 percent federal income tax rate for C corporations. For this and other reasons, some pass-through entities have decided to convert to C corporation status entirely or partially.
Future Distributions to Owners
Many pass-through businesses make “tax distributions” to their owners to cover the owners’ federal and state income tax liabilities for their share of the business income. Generally, partners and S corporation shareholders are not taxed on such distributions (because they have already been taxed on the underlying income).
On the other hand, C corporation shareholders are not taxed on their share of C corporation earnings until the earnings are distributed, and therefore tax distributions are unnecessary. Distributions from a C corporation, however, are subject to a second level of taxation at the owner level, generally at a 23.8 percent federal tax rate. (Section 1(h)(11) (20 percent highest marginal qualified dividend federal income tax rate) and Section 1411(a) (3.8 percent Net Investment Income tax rate).)
The additional 23.8 percent federal income tax on dividends from earnings that have already been subject to the 21 percent entity-level corporate income tax rate mitigates the benefit of the 21 percent entity-level corporate income tax rate over the 29.6 percent to 37 percent range of effective pass-through business federal income tax rates discussed above. Accordingly, the desired level of future distributions to owners impacts the conversion analysis.
Generally, the more earnings a business plans to distribute in the future, the less likely it is to decide to convert to C corporation status. Further, an S corporation that decides to convert should be aware that it may make tax-free distributions of cash before or after conversion depending on the type of conversion and to certain shareholders. (See generally Sections 1368, 1371(e), 1371(f).)
State Income Taxes
State income taxes and rates can also significantly impact the analysis. For example, many pass-through business owners residing in states such as California and New York may pay state income tax on the pass-through business’s taxable income at income tax rates above 10 percent.
Individuals are generally subject to income tax on their entire earnings from a pass-through business in their resident state; however, the same pass-through business taxed as a C corporation may have a significantly lower effective state tax rate, whether because of apportionment or because of “no-where” sales to states where it does not have income tax nexus.
Furthermore, state income taxes are generally deductible by corporations, while individuals may only deduct $10,000 of state income taxes per year. On the other hand, in some cases (for example, in states like Florida), state corporate income tax rates are significantly higher than state individual income tax rates.
Next Steps if You are Considering Changing Corporate Status
There are many other things to consider before change corporate structure, including estate taxes and planning, exit planning and compensation planning. Freeman Tax Law specializes in guiding individuals and companies through these situations. Please contact our office to schedule a complimentary consultation to discuss your specific needs and requirements.