With the new Tax Cuts and Jobs Act, or TCJA, in effect, business owners should be questioning whether their current entity status is optimal.
For example, many companies are taxed as S corporations since money can generally be taken out of the business tax-free, avoiding the double taxation associated with a C corporation. However, with the new law, C corporations are taxed at a rate of 21 percent, which is much lower than the pre-act rate of 34 percent. This means it may be time to reconsider entity status.
There are several factors to consider when deciding whether to change. For 2018, the highest tax bracket for individuals is 37 percent. To equalize the tax effect between S corporations and C corporations, the TCJA created a 20 percent deduction for qualified business income, or QBI, of flow-through entities. This results in S corporation business owners only being taxed on 80 percent of their company’s income. However, if taxable income is greater than $315,000 for joint filers, limitations can either reduce the deduction or eliminate it. The deduction cannot exceed 50 percent of the owner’s share of W-2 wages or 25 percent of W-2 wages plus 2.5 percent of unadjusted basis of qualifying property. In addition, businesses that are classified as a “specified service business” are not allowed to take advantage of the QBI deduction. If an individual at the highest tax bracket is allowed to take the full QBI deduction, it can effectively lower their rate on flow-through income to 29.6 percent, which is still higher than a C corporation.
Besides the rate difference, business owners need to consider what they want to accomplish and their overall goals within the business. If it is their intention to highly compensate themselves, then an S corporation would be advantageous because as long as the owners have basis in the entity, they can take tax-free distributions. With a C corporation, dividends are taxable to the owner, creating a second layer of tax. Therefore, C corporation owners are forced to compensate themselves through a higher W-2 salary, which also is subject to additional payroll taxes. On the other hand, a C corporation is a better option if owners want to keep cash in the company to grow, pay down debt or invest due to the fact that the corporate tax rate is so low.
Owners also need to consider their exit and succession plans. The sale of assets in a C corporation is subject to double taxation. Businesses converting from an S corporation to a C corporation will have to wait five years before they are eligible to re-elect S status. Then, if they decide to re-elect S status, the company would need to wait an additional five years to avoid the evil built-in gains tax. Essentially, if a company wants to switch from an S to a C, they will need to wait 10 years to convert back to an S in order to completely avoid unfavorable tax consequences.
Now is the time to reconsider your entity’s status for the 2019 tax year. For year-end, the election or revocation for 2019 needs to be made by March 15th.