One of the most drastic changes in the Tax Cuts and Jobs Act was a reduction in the Federal Corporate Income Tax Rate from 35% to 21%. This change, in turn, has many business taxpayers currently organized as an S Corporation or an LLC (and thereby subject to pass-through taxation on their personal return) inquiring if it makes sense from a tax perspective to switch to taxation as a C Corporation.
The primary difference between corporate and pass-through taxation has to do with how many layers of tax income is subject to prior to ultimately landing in the owner’s pockets. Corporate taxation is subject to “double” taxation since the income is first subject to a corporate level tax and then again when the remaining income is passed to owners in the form of dividends. Pass-through taxation is only subject to a single layer on the owner’s individual returns, regardless of any distributions made. This income is taxed as ordinary income rates to the individual (as high as 37%), rather than a preferred rate for capital gains and qualified dividends (which will cap out at 23.8%).
On the surface, it seems as if the lower corporate rate combined with the lower dividend rate means that a switch to a C Corporation may make sense for a lot of enterprises. However, there is another less discussed factor that has a very significant impact on this change, State and Local Taxes. Many pass-through entities are not subject to any State and Local taxes (or have inconsequential state filings fees and franchise taxes not based on income); a change to a C Corporation will now subject this income to 2 layers of State and Local tax as well.
As a simple example, Joe is the 100% owner of MBC, Inc, which provides consulting services (note: as will be covered in future tax blog posts, there is a change to pass-through taxation; we are assuming this taxpayer does not qualify). After paying all expenses (including reasonable compensation to himself), he is left with a pool of $1,000,000 of cash which was generated all from income and he wants to pay the least in taxes and get the most to himself.
As this simple example shows, even with the lower rates, the double taxation results in a higher effective tax rate. Taxpayers should do a more detailed and complex analysis of all the related facts and their circumstances to see if a change to a C Corporation for tax purposes makes sense. For many years the default choice for most businesses has been to structure as pass-through entities; even with the change in C Corporation rates, this likely will still hold true for many taxpayers. Even if the change may result in some tax savings, additional analysis should be done to consider all the implications of the switch, such as exit plans, anticipation of future changes and management style of the company.