On December 22, 2017, the Tax Cuts & Jobs Act
(TCJA) was passed into law, ushering in tax reform that
will affect most, if not all, Americans. The changes
to the tax code took effect on January 1, 2018. Of all
of the provisions contained in the TCJA, one is attracting
the attention of small business owners, making
them consider whether they should reorganize as a
C corporation.
The new reduction of the maximum corporate tax
rate from 35 percent to 21 percent only applies to
companies that are structured as “C” corporations.
However, most small businesses are set up as either “S”
corporations or partnerships, referred to as passthrough
entities, which have elected to be taxed on
their profits at the owner’s personal tax rate. Since the
TCJA reduced individual tax rates very little, some small
business owners are considering reorganizing as C
corporations. The decision will depend on a number
of considerations.
The first consideration is that pass-through entities
are taxed only once, although at a higher rate under
the new tax law, while C corporations can be taxed
twice: at the 21 percent rate, and again at the owner’s
individual rates if any of the corporation’s profits are
paid out to the owners as dividends. If owners are not
planning to pull a lot of cash out of a business but
intend to reinvest most of the profits back into the
company, a C corporation could be considered. Also, C
corporations can still deduct all state and local taxes,
while individuals are limited to a maximum deduction
of $10,000 per year. This can be an important factor for
companies that are generating income in multiple
jurisdictions. One factor against converting, however,
is an impending sale, since a sale will necessarily
require a distribution to owners, triggering two levels
of taxation.
Another factor to consider is that the law provides
a benefit for pass-through businesses that generate
less than $315,000 in annual gross income (for a married
couple filing jointly). These companies will be
shielded from paying the higher personal rate because
a deduction of up to 20% of income may apply. There
are a number of exceptions to this deduction however,
including the fact that it does not apply to income from
“professional services” (legal, financial, consulting,
tax, and freelance services), so professional service
providers may be prime candidates for conversion.
The savings should be more than the conversion
expense, so it’s essential to do a full analysis first. Also,
note that while the reduction to the corporate tax rate
purports to be permanent, any shakeup in Congress
(such as a return to control by Democrats) could give
rise to further changes or reversions. It would be far
more difficult to revert back to an S corporation or partnership
once the C corporation conversion is complete.
Most entities have to wait 5 years before they can revert
to an S corporation election.
Once you decide that converting your S corporation
or partnership into a C corporation is the right
thing to do, the process can be simple or complicated
depending on how you are currently structured.
Companies already set up as corporations (with Inc.,
Incorporated or Corporation in their names) must file a
change of status with the IRS, by filing a letter of
revocation. The corporation’s employee identification
number (EIN), business address, number of corporate
shares, and shareholders’ resolution used to approve
the revocation should be included in the letter. To be
effective on the first day of the corporation’s taxable
year, the company should revoke its S corporation election
by the fifteenth day of the third month of that tax
year—by March 15, 2018 for the current tax year—otherwise
the election cannot be effective before the date
of filing. Limited liability companies must reorganize
completely by filing a plan of conversion (from LLC to a
corporation) with their Secretary of State. Many states
provide for streamlined or statutory conversions that
can be completed easily. However, some states have a
more complicated process. Once filed, the revocation or
change of tax election would be filed with the IRS.
The Tax Cuts & Jobs Act will certainly have a
profound impact on small business owners in many
ways. Looking at the tax ramifications of keeping or
revoking their pass-through tax status is one that
should be analyzed by each business owner.
Business Insights is hosted by the Law Firm of KPPB LAW (www.kppblaw.com).
Sonjui L. Kumar is a founding partner of KPPB LAW, practicing in the area of corporate law and governance.
Disclaimer: This article is for general information purposes only, and does not constitute legal, tax, or other professional advice.