Now that the much-awaited tax bill has been passed and signed into law, there are a number of questions that our clients are asking us. One of them deals with corporate tax rates. As far back as when President Trump was campaigning for office, he was indicating that there was going to be a significant decrease in corporate tax rates. At that point, there was general consensus that pass-through entities, such as subchapter S corporations and partnerships would get similarly beneficial treatment.
Now that the law has been established for 2018 and forward, it turns out that the rates for C corporations are more advantageous than the ones for smaller corporations. The question, then, that we are getting from our many S corporation clients is whether it makes sense to convert from an S corp to a C corp.
As we will see, just because the federal tax rates are more conducive to C corporations, there may be little motivation to consider moving away from S corporation status.
The new federal rate for C corporations is 21%. S corporations, taxed at the shareholder rate on his or her personal return, receive a 20% deduction on income from the pass-through entity. Assuming that the shareholder is in the highest individual tax bracket, which will be 37% in 2018, the effective federal tax rate on an S corporation is 29.6%
- C corporation Rate: 21%
- Pass-through Rate: 20% deduction on income from pass-through
- Effectively 80% of individual rate
- Highest individual rate= 37%
- S corporation rate: 29.6
From this perspective, it appears to be an easy decision for S corporations to want to explore conversion to a C corporation; however, if these corporations are in the state of Pennsylvania, the rate swing evens out a bit. Despite the federal rate being 8.6 percent lower for C corporations, the PA rate is almost 7 percent higher.
- C corporation:
- Federal Rate: 21%
- PA Rate: 9.9%
- Total Rate: 30.99%
- S corporation
- Federal Rate: 29.6%
- PA Rate: 3.07%
- Total Rate: 32.67%
There are a few details about the 20% deduction, and there is a component whereby state taxes are a federal deduction that is not calculated above, but the overall combined rate is much closer when considering PA.
For businesses that have operations in multiple states, the allocation of state income may be different and there may be less variance in rates, potentially causing more of a difference between S and C rates.
In addition to tax rates, the other issue between and S and C corporations is the distribution of compensation, specifically between wages and dividends.
In a C corp, a shareholder who is also the President may make $2 million. But, if $750,000 is for work as President and $1.25 million is for the results and profits of the corporation, that amount should be a dividend. Dividends are taxed differently for S and C corporations. Neither type treats them as deductible expenses, so they don’t decrease corporate income, but for an S corp, they are not taxed to the recipient. C corp dividends, on the other hand, are taxable income to the recipient.
So, for the portion of income that is treated as a dividend, the total taxes that are paid on that dividend are still higher for a C corp than an S corp.
- C corporations:
- Corporate Rate: 20%
- Dividend Rate: 20% (long-term capital gains)
- Total Rate: 40%
- S corporations:
- Corporate Rate: 29.6%
- Dividend Rate: 0%
- Total Rate: 29.6%
Consequently, corporations with shareholders taking significant bonuses at year-end will not necessarily benefit by a move to a C corp because some of those bonuses will have to be treated as dividends.
There is also a matter of equity retention. Corporations, such as manufacturers, that, because of the significant machinery to maintain and purchase, leave a lot of money in the corporation will possibly have more reason to move to C corp from S corp than a service organization that strips out most of the earnings at the end of the year in the form of employee and management bonuses.
It is important to note that each individual company has its own set of facts and circumstances, so we will be advising our clients on a case-by-case basis, and you should consult your professional before acting on anything. However, despite the tax law looking to benefit C corporations to a greater extent than S corporations, to paraphrase Mark Twain, “The reports of the S corp’s death are greatly exaggerated.”
By Dan Massey, CPA, Manager