There are many questions businesses have as the result of the Tax Cuts and Jobs Act (TCJA)—among them, how should they structure their companies for optimal tax outcomes in light of the reduction in the corporate tax rate. Under previous legislation, the corporate tax rate was 35%; the TCJA lowered that rate to 21%. This change leaves many shareholders of S corporations questioning if it makes sense to terminate S status in favor of becoming a C corporation. For a better understanding of the effect of the new corporate tax rate, one must first understand the difference between the two statuses.
The defining difference between the S corporation and C corporation is the entity responsible for income tax. The C corporation is considered, for income tax purposes, a separate entity from its shareholders—it is assessed an income tax on corporate earnings at the corporate tax rate. An area of significant anguish for many C corporation owners is the additional tax shareholders pay on the distributed income of the corporation in the form of dividends, which are taxed at a capital gains tax rate up to 20%, depending on the shareholder’s tax rate. In effect, the C corporation is taxed not just once, but twice. If the corporation is not consistently distributing income to the shareholders as a means of bypassing this capital gains tax, the undistributed income can be potentially subject to an accumulated earnings tax of 20%.
On the other hand, unlike a C corporation, an S corporation is generally not taxed at the corporate level. Instead, an S corporation elects to have the income, losses, deductions, and credits of the corporation pass through to the individual tax returns of the corporate shareholders. Because of its ability to bypass the double taxation of corporate income, the S corporation has, in recent years, become the formation of choice for eligible corporations. However, with this benefit appears another cost: Shareholders of the S corporation must report their undistributed shares of corporate income, which is subject to tax at their tax rate, on their tax returns.
The new tax rate under the TCJA is now of greater importance for S corporation shareholders who are taxed at an individual rate higher than the corporate tax rate. On paper, a 21% corporate tax rate, compared to an individual marginal tax rate that is greater than the corporate rate, could imply a lower tax burden. In actuality, the lower corporate tax rate cannot be considered in isolation. It is essential for shareholders to consider other factors, such as their effective tax rates, which show taxes paid as a percentage of total taxable income, and do not necessarily equal the marginal tax rate that taxpayers typically consider.
Also important to consider is the potential for dividend distributions of C corporation earnings, which are subject to a capital gains tax, as earnings accumulation without consistent income distribution can be subject to an accumulated earnings tax, if the business purpose of the accumulation is in question. The accumulated earnings tax, when taken into consideration with the corporate tax rate, could potentially result in a greater tax burden than the effective tax rate of the shareholders.
Research and planning to understand the actual implications of converting a corporation before deciding to revoke S status can prevent a serious nightmare of unexpected tax. One should speak with a tax advisor to determine the best corporate tax strategy to employ. If you would like more information about the tax implications of revoking the S status of your organization as a result of the TCJA, or would like help mapping out a tax strategy for your business, contact one of our PYA executives below at (800) 270-9629.
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