Is NOW The Time To Revisit Choice Of Entity?
With the 2018 C Corp tax rate now at 21 percent (in addition to the lack of a state income tax in Ohio on C Corporations) you may be flirting with the thought of converting your existing flow-through entity to a C Corp. But before you do something rash, distance yourself from the hype and give the decision the careful consideration it deserves. After all, even with their lower tax rates, C Corps historically tend to score lower when it comes to popularity among business owners – and for good reason.
Before switching your choice of entity to a C Corp, talk with your tax advisor to ensure that you fully understand the following critical points:
- More Manageable Tax Rate: Non-professional service entities will pay a 29.6 percent federal tax rate on business income (20 percent deduction for 2018 in addition to a reduced highest tax bracket of 37 percent) starting Jan. 1, 2018.
- Observe The Forest Through The Trees: While C Corp rates are now lower (8.6 percent to 16 percent depending on your facts) than pass-through rates, this short-term benefit must be weighed against the long-term detriment of being subjected to the two layers of tax on proceeds from the future sale of a business’s assets when the owner(s) retire.
- Reinvest For Success: Companies looking to reinvest capital – not distribute profits to owners – may be a candidate for a conversion to a C Corp.
- Retained Profits Income Won’t Soften The Blow: Unlike with pass-through entities, retained profits income in a C Corp do not increase stock basis for later tax free distributions, nor will they reduce the taxable gain on the future sale of the company.
- Flip-Flopping Is Not An Option: Once an S Corp election is terminated and the entity is converted to a C Corp, you must wait five-years before you can re-elect S status.
- Accounting Method Change Could Trigger Tax Liability: If the current business is on the “cash” method of accounting, a change to the “accrual” method will be required where average gross revenues exceed $25 million at time of conversion. This conversion likely will trigger a tax liability.
- Potential Planning For Intangibles Prior To Conversion: The existence of business intangibles (e.g. goodwill) and who owns them should be evaluated and ownership identified and segregated in legal documents. This may allow Long Term Capital gain treatment to the shareholder directly, avoiding the C Corporation structure altogether for a part of any future business sale, as well as the double tax and lack of LTCG rate of a C Corp (21 percent vs 20 percent).
- Taxable Post Termination Period For S Corps: After a corporation conversion, there is a two-year post termination period to take out previously taxed S Corp income (“AAA” account). There is a ratio of AAA (tax-free) to previous C Corp E&P (taxable at 23.8 percent dividend rate) that is required so the entire post termination period distribution may not be 100 percent tax free.
- Potential Deal Breaker: In some cases converting to a C Corp could trigger an immediate tax for sole proprietorships (including single-member LLCs) and partnerships with “underwater” balance sheets at the time of conversion.
Don’t let the threat of time push you into making a decision you will regret later. Choice of entity is a big decision. One in which you should carefully consider all possible ramifications. Some business owners may actually find it more beneficial to stick with a pass through entity.
The only way to truly know whether it makes sense for you to take advantage of the lower 2018 tax rates by converting your current flow-through entity to a C Corp is to talk to your tax planner. Your company’s tax situation is unique and there are several issues to consider before making such a large financial decision. Email Rea & Associates to learn more or to set up a time to speak with one of our tax experts.
By Christopher Axene, CPA (Dublin office)
Learn more about considerations associated with choice of entity. Check out these resources:
Podcast: Control Your Bottom Line By Identifying Your Business Entity, Wisely