For decades, business owners debated the merits of switching from a C corp to an S corp, mainly for the tax advantages offered by an S corp to its owners. With the new tax act in place, the debate has flipped, and S corp owners are wondering if changing to a C corp might be advantageous.
Framing the Debate
S corps and other “pass-through” entities generally do not pay income taxes at the corporate level. Rather, S corps pass through their income to their owners, who pay tax on their S corp income at their individual tax rate.
The new tax law lowered the top corporate tax rate from 35% to 21% but kept the individual tax rates at a higher level. For some owners, a potentially lower overall tax rate might make a C corp more attractive.
To address this issue, the government established IRS Section 199A, which allows a deduction for qualified business income (QBI) for taxpayers— other than C corps—that meet certain requirements.
The deduction is limited to the greater of 50% of W-2 wages or the sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis (UBIA) of certain property used by the business. After applying various limitations, the deduction actually allowed is based on the lesser of the allowed deduction or 20% of taxable income.
When calculating QBI, “qualified” businesses do not include specified trade or businesses (SSTBs) involved in healthcare, law, accounting, consulting, athletics, financial services, brokerage services, or any trade or business that depends on the reputation or skill of the owners or employees.
The deduction is phased out for joint filers with taxable income between $315,000 and $415,000 and for all other taxpayers with taxable income between $157,500 and $207,500.
When Does Conversion Make Sense?
With the QBI deduction, the effective tax rate is 29.6% for qualified pass-through entities, versus 21% for C corps. Also, under a C corp, stockholders are subject to double taxation on dividends issued by the company.
Does it make sense to convert to a C corp if the overall taxes are still higher when factoring in dividends, double taxation, and the possibility that tax laws may change under a new administration? Maybe.
For example, S corp shareholders who want to attract new investors and plan for ongoing operations for more than five years might benefit from IRS Section 1202, also known as the Small Business Stock Gains Exclusion.
This regulation allows capital gains from certain small business stock sales to be partially or fully excluded from federal tax. Converting to a C corp, waiting to sell newly issued shares for at least five years, and meeting certain other criteria allows new shareholders to sell their stock tax-free, up to the greater of $10 million or 10 times the adjusted basis of their stock.
Note that not all small business stocks qualify for this tax break, and it applies only to new shareholders after conversion.
Talk to Your Tax Advisor
There may be other circumstances where conversion to a C corp would make sense, but the most prudent way to proceed is to discuss your situation with your CPA.