The 2017 Tax Act made major changes to the US tax system, and as a result, many business owners are wondering whether they should structure their businesses as C corporations or S corporations. Which choice makes the most sense for your business? We sat down with CPA Bob Russell, who files between 900 and 1000 tax returns a year, for his input.
In your opinion, what are the important differences between C and S, and what should business owners know if they are going to reorganize themselves as C corps?
There are two important factors when considering reorganizing from an S corp to a C corp. The first and most important is the double taxation issue. The corporate tax rate was changed to a flat 21% under the new tax reform, changing from the graduated rates experienced by C corps prior to 2018. So in the simplest scenario, if a C corp has a net income of $100,000, the corporation will pay $21,000 in federal income tax. Now, when the corporation declares a dividend and passes that same $100,000 to the underlying shareholders, they will be taxed again on the same income at their personal income tax rates. Dividends are not considered operating expenses of C corps, so they get no deduction against future income for payment of dividends. Even at the lowest personal rates, this results in a total tax rate of 31% taxation on the same $100.000.
My experience is that very few people who have money to invest in the stock of a C corp fall in the lowest tax brackets, so a more realistic expectation is that the total tax would be closer to 43% for federal income tax purposes. With an S corp, the $100,000 of net income under our example has no tax at the corporate level, and flows directly to the underlying shareholders and is taxed at their individual rate. In addition, under the new tax reform, this will be considered qualified business income, subject to 20% reduction mentioned later in our discussion.
The second consideration is once you have revoked your Sub S status with the IRS, you cannot reapply for five years. That means you should carefully consider the future of the corporation and determine if revoking your S election is the best long-term strategy.
Do you anticipate that you will be filing more C corporations now that people are reacting to the tax reform?
I don’t anticipate that. The issue with C corporations is still double taxation. Even with the reduced tax rates that C corps are going to benefit from under tax reform, the total tax burden can still exceed the tax burden of the underlying shareholders if the income was passed directly through to them and taxed at the individual rates, as is the case in an S corp.
Would you say there are positive aspects of this tax law for small business? If so, what are they?
There are definitely some positive changes for small businesses. The most impactful change is the 20% reduction of qualified business income. This reduction is going to apply to all business entities including sole proprietors, partnerships, LLC’s and S corps. This reduction is an attempt to compensate non-C corp entities for the reduction in the corporate tax rate under the new tax reform act.
What do you think are key things small business owners should keep in mind during this time?
Above all else, don’t panic and make a change based on emotion. It is easy to listen to the soundbites and think that C corps are the best answer for everyone. However, they should carefully consult their tax advisor to fully understand all the implications that impact their particular situation before making any changes.
Secondly, some changes that have taken effect may affect their operating strategies. Meals and entertainment are no longer deductible unless for the benefit of employees, i.e. Christmas parties. Also, unreimbursed expenses that their employees incur are no longer deductible by those employees. Consider implementing an accountable plan and making those expenses business expenses, and therefore fully deductible. Be creative with your employees in determining their overall compensation plan.
We hope this gives some insight into what these changes mean! When choosing your business entity or correctly structuring your company, talking to an accountant or business lawyer is a great idea. Here’s to your success!
Bob Russell is a self-employed certified public accountant practicing in Oregon since 1982, focusing on individual and small business taxation. Currently our practice services approximately 900 individual, partnership, and corporate accounts. Areas of emphasis in our current practice include manufacturing and construction industries. Bob graduated cum laude from Southern Oregon State College with a Bachelors of Accounting and a minor in Economics. Bob resides with his wife of 34 years on seven acres in the Beavercreek area, and enjoys hunting and golf in his spare time.