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The passage of the Tax Cuts and Jobs Act of 2017 has business owners evaluating whether it may be more advantageous to be taxed as a C corporation, despite the “double taxation” of C corp shareholders. The answer to whether your business should be taxed as a C corp, an S corp, or a partnership is not a simple one. Getting to the right answer depends on your particular circumstances and the analysis should involve your lawyer and your accountant working together.
The new Act is pretty terrible for pass-through business entities such as partnerships, S corps, and LLCs. It eliminates most pass-through deductions that business owners take for granted, and puts the taxable rate for owner distributions at roughly 37%. Meanwhile, C corporations have had their taxes slashed to 21%. Converting from a pass-through to a C corp also preserves deduction of certain expenditures in the business and may reduce your overall tax burden because those company expenses would flow back to the owner as income in a pass-through entity.
But about that double taxation on C corps…
While the corporation pays a tax of 21%, the typical small business owner works for the business and would pay a 15% self-employment tax plus 3% to 4% on investment earnings, which could result in a 35-39% tax basis overall for the owner and the corporation. If your business posts losses your first year, those losses would not flow through to you if your company becomes a C Corporation, and your ability to make deductions at the corporate level could be irrelevant if, for example, you aren’t able to contribute to a pension plan or pay for health insurance through your business.
Moreover, If you plan on selling your business anytime soon, C corp status would be disadvantageous. A typical asset sale (the most common way to sell a small business) would result in two levels of tax for a C corp – one tax to the corporation when it sells its assets and a second tax to the shareholders when they cash out their shares. But an asset sale in an LLC or S corp would result in all of the proceeds passing through to the owners directly, and you would only be taxed one time on the proceeds.
While taxes are certainly a big part of the equation, they are not the only consideration. A C corp is not as administratively flexible as an LLC or an S Corporation. C corps need to observe more formalities, such as having a board of directors and annual shareholders meetings. Your corporate tax return may be more onerous.
Finally, converting an LLC or S corp to a C corp is a one-way street: you can’t change your mind and simply become an LLC again. There is a statutory time period during which you cannot convert back. Under U.S. Treasury Regulations § 301.7701-3, a business entity may choose or change its federal tax classification by simply completing and filing IRS form 8832, and C corp status is the default for corporations. If your business is an LLC, you can simply convert the LLC to a corporation and accept the C corp status. If your business is a corporation previously taxed as an S corporation, you can simply revoke that election on Form 8832. But after you convert to a C corp, you can’t go back because the IRS treats the conversion of a C corp to a pass-through entity as though you have liquidated the corporation and paying taxes on the “proceeds” of the liquidation event.
So my recommendation? Have your CPA do the math and make sure you understand the benefits and ramifications of your decision before converting your LLC or S corp to a C corporation. As always, we are here to help you figure out if and when to make that leap.