Traditionally, if a corporation met the eligibility requirements of an S-Corporation, then it is almost always advisable to elect “S” status for small corporations. However, amidst the fiscal cliff tax act of 2012, some of our clients have explored the option of converting to a C-Corporation. While the results of an empirical analysis are important, other often overlooked ramifications should be considered.
By way of background, many businesses incorporate to shield its owners from personal liability as a result of acts of the business. Most small businesses organize as “pass-thru entities,” which are S-Corporations, Limited Liability Companies (LLC’s), or partnerships. Such entities are called “pass-thru entities” because the entity itself does not pay tax; rather the income is taxed when it “passes through” to the owners. In a simple example if ABC, Inc. earns $100 and it has 2 owners taxed at a 35% rate, it will not pay tax on $100. Rather the owners will report income of $50 and pay tax of $17.50.
In contrast, the traditional C-Corporation is not a “pass thru entity,” because a corporation is taxed twice. The C-Corporation is taxed on income it earns and then is taxed again when its earnings are distributed to its shareholders in the form of a dividend. In my simple example, if ABC, Inc. was a C-Corporation, it would be taxed at 35% on its $100 of income, resulting in $35 of tax at the corporate level. Upon distributing its remaining $65 to its lone shareholder, the income would get taxed again. Assuming the old 15% tax rate on dividends, the shareholder would then pay another $9.75 in tax. Therefore, purely because of its structure, $9.75 in additional tax would be due if the company were set up this way. Adding several 0’s to my simple example, one can easily see how this simple example can quickly become an issue.
So the obvious question arises – why would anyone want to set up as a C-Corporation? The simple answer is that absent some unusual fact, most corporations would prefer to be an S-Corp. Further, Subchapter S of the Internal Revenue Code places several restrictions on electing “S” status, such as the corporation cannot have more than 100 shareholders, it can only have 1 class of stock, and the shareholders cannot be partnerships, corporations, or non-resident aliens. It is the 100 shareholder requirement that prevents many large companies from electing “S” status.
With that background in mind, the recent wrinkle is that the recent Tax Act has raised individual rates from 35% to 39.6%. In turn, owners of pass-thru’s now have a higher tax obligation on income, which has narrowed the tax gap. With the individual rate higher than the corporate rate of 35%, more and more companies are considering switching from S to C and leaving income within the corporation. All other things being equal, this actually does create a tax savings. However, many taxpayers fail to consider a number of other problems this switch creates.
Many states, such as Florida, apply state corporate income tax to only C-Corps and not to S-Corps. Depending on the tax rate, this can gobble up a large chunk of the savings right off the top. Further, if part or all of the C-Corporation’s assets are sold, the gain from those sales will result in double tax under the corporate tax regime. In addition, the earnings will have to be pulled out of the corporation at some point and will be taxed again at that time, if the corporation is a C. Perhaps one of the most important points to consider is that once a corporation converts to a C-Corp, the corporation must wait 5 years before re-electing S status.
While it ultimately is an empirical analysis, there are many points one should consider if he/she is choosing to change from an S to a C. Such a move is rarely worthwhile based solely on the tax rate change as many of our clients have considered. The corporation should also consider state income tax, potential assets or business sales, and how much of the income it plans to extract to the shareholders. In any case one should consult his/her tax advisor before making the bold move of switching from an S to a C.
About the author: Mr. Donnini is a multi-state sales and use tax attorney and an associate in the law firm Moffa, Gainor, & Sutton, PA, based in Fort Lauderdale, Florida. Mr. Donnini’s primary practice is multi-state sales and use tax as well as state corporate income tax controversy. Mr. Donnini also practices in the areas of federal tax controversy, federal estate planning, and Florida probate. Mr. Donnini is currently pursuing his LL.M. in Taxation at NYU. If you have any questions please do not hesitate to contact him via email or phone listed on this page.