A lot depends on whether you plan to sell soon or hold onto the firm.
5 min read
Opinions expressed by Entrepreneur contributors are their own.
Now that the tax filing season is over, it’s a good time for companies wanting to take even greater advantage of tax law changes to examine the structure of their businesses. It just might save them money.
Many owners of pass-through entities are wondering whether becoming a C corporation is the right move because of the lower 21 percent corporate tax rate that was part of recent tax reform legislation.
While a 21 percent tax rate is certainly a head-turning number compared to the top individual rate of 37 percent, discerning what is actually the best entity structure for a business is a complex matter that requires some considered analysis. That analysis starts with knowing how much of the firm’s earnings will be distributed. For comparison purposes, pass-through entity owners could pay up to 37 percent on income, but if they qualify for a new 20 percent pass-through deduction, they will pay an effective tax rate of 29.6 percent. They will not pay any tax on income when it is distributed.
Tax advantages of a C corp can be huge.
How does a C corp stack up against that? A C corp will pay 21 percent on its operating income, but its effective tax rate is determined by how much of its earnings are retained or distributed since shareholders are taxed on dividends paid by a C corp.
A C corp that distributes all of its earnings pays an effective rate of 39.8 percent, but a firm distributing half of its earnings will pay 30.4 percent. A C corp retaining all of its earnings pays an effective tax rate of 21 percent. Now those C corps retaining their earnings will have to pay them out eventually — so the shareholders are not escaping tax altogether but simply delaying it into the future.
So, whether a firm plans to retain some or all of its earnings is a major consideration. Firms where owners are well paid in salary and can thus retain earnings to grow the business may favor a C corp structure.
Any company contemplating a change needs to develop long-term business forecasts, including the impact of various scenarios that could alter the tax picture. A major question in running that analysis is what the owners are planning for the business.
When does switching to a C corp make sense?
If the owners are planning on keeping the company for a considerable period of time, perhaps handing it over to heirs, then switching to a C corp could make sense. If, on the other hand, the owners plan to sell, the structure of that future sale will largely determine the best entity. For instance, in an industry where the sale of the firm would take place as primarily a purchase of assets, C corp status could result in a higher tax bill and so would be undesirable.
But, if the business was sold as a stock sale, a C corp status could minimize the tax bill in such a transaction. Consideration would also need to be given to whether a purchaser will pay more or less for the company based on those differing structures.
In the case of a business planning a period of capital expansion, it can make particular sense to restructure as a C corp. As long as new stock issued by the corporation is retained for five years, the shareholders can avoid 100 percent of their tax obligations on the sale of stock under Sec. 1202 of the tax code. Many states follow this provision as well. Even a company that is just changing its structure to a C corp may also be able to qualify for this benefit.
In some circumstances, it makes sense to reorganize from an S corp to a C corp and back again. For example, if a corporation plans to make significant capital growth through retained earnings, it can elect to be a C corp to enjoy lower taxes during the period of growth. Then, after five years it can switch back to S status, avoiding the tax on built-in gains from Sec. 1374 of the tax code — so long as the business is not sold for another five years.
You’ll get greater flexibility with benefits.
Another advantage for C corp owners who are also employees of the firm is more flexibility with fringe benefits. They are able to set up Cafeteria Plans where employees are reimbursed for such things as transportation costs, insurance premiums, medical expenses and dependent daycare expenses.
Tax filings, too, can be simpler for C corporations, especially compared to S corps when earnings flow through to owners, generating complex individual returns and requiring estimated quarterly payments for both the corporation and each individual owner.
A final consideration is how much state tax the corporation pays. After the recent tax changes, C corps can still deduct all their state and local taxes (SALT) whereas owners of pass-throughs can only deduct up to $10,000 in SALT deductions. That can be a significant consideration in states with higher state and local taxes, such as New York, California and New Jersey.
Reorganizing your business should only be done after consulting with a specialist who can help crunch the numbers and run a cost-benefit analysis. Of course, any analysis is only as good as the business data and forecasts that are input at the start of the process. So, it’s essential to take the time to create robust data and to consider various future scenarios about such things as a potential sale or transfer of the business.
Done well, that analysis will produce a plan to take full advantage of every tax code opportunity.