It’s been more than 18 months since the Tax Cuts and Jobs Act was signed into law, but businesses are still adjusting to many of its sweeping changes. Some of the new rules are causing contractors to rethink some basic assumptions that have been the foundation of their business and tax planning for decades.
For example, new tax rates have caused some contractors to wonder whether structuring their companies as pass-through entities is still a wise move or whether they might reduce their total tax burden by reverting to traditional C-corporation status. Before making such a fundamental change, it’s important to think through all possible ramifications. In most instances, there can be unforeseen—and unpleasant—consequences.
S Corp or C Corp—Comparing the Numbers
At first glance, it might appear that structuring your business as a pass-through entity is no longer as beneficial as it was prior to tax reform. C-corporation income is now taxed at a flat rate of 21 percent, but owners of pass-through entities are taxed at individual tax rates, which still could be as high as 37 percent.
To offset this disparity, Section 199A of the Internal Revenue Code allows sole proprietors, partners, and owners of pass-through entities to deduct up to 20 percent of their net “qualified business income” on their personal returns. But that still leaves an effective tax rate of 29.6 percent, compared to the 21 percent cap on C-corporation income taxes.
In addition, the term “qualified business income” is subject to a number of limitations. In many cases, a sizable portion of a pass-through owner’s income might not be eligible for the deduction.
For example, if you are an S-corporation shareholder, the Section 199A deduction applies only to the profits that are reported to you on Form K-1. Wages you earn as an officer of the company are not considered “qualified business income” and therefore are not eligible for the 20 percent deduction. Similarly, guaranteed payments associated with partnerships and LLCs also are excluded from “qualified business income.”
Furthermore, the deduction begins to phase out if your taxable income (including income from all other sources) exceeds $157,500 (or $315,000 if you are filing a joint return). The phaseout is calculated using several complex formulas that take into account the total wages paid to all employees and other factors.
Finally, like most of the individual income tax provisions of the new law, the Section 199A deduction will expire in 2026 unless Congress takes additional action. Obviously, no one can say what political and economic factors will drive lawmakers’ decisions between now and then.
With so many caveats, it’s easy to see why reverting to C corporation status might appear advantageous at first glance. But there are other factors to consider.
Chief among these is the issue of double taxation, which has always been the primary argument in favor of pass-through entities. Income earned by a C corporation is subject to federal corporate income tax at the entity level and then taxed a second time at the shareholder level when the corporation distributes that income as a dividend. In many cases, this would more than offset any benefit you might gain by reverting to C-corporation status.
You should also consider your long-term plans for the company. The stock basis for C corporations generally stays the same from year to year, but S-corporation shareholders’ stock basis typically changes every year according to the company’s performance. Repeated step-ups in basis that accumulate over the years can result in significant capital gains tax savings when the shares are sold or passed on to heirs.
Here’s one more point to bear in mind: If you do decide to give up your S-corporation election, you cannot go back and reinstate it for a period of five years. A lot can change during that time, and there’s no guarantee the tax code will not undergo further revisions. So before making such a critical decision, spend some time working with your accountant to run the numbers and factor in as many variables as possible.