Should I Convert to a C Corporation?

Melissa Lanigan, CPA (Jan, 2019)

Since the Tax Cuts and Jobs Act (TCJA) passed on December 22, 2017 word has spread about the new, significantly lower, permanent, corporate flat tax rate of 21%.  The question that went through every business owner's mind was: Should I convert my S corporation to a C corporation? As CPAs we have been receiving this question A LOT.  For many, the first initial reaction was to jump ship and convert to a C corporation.  But the real answer is, it depends!   

Aside from the lower corporate tax rate there are other issues and items to consider before converting your S corporation to a C corporation.  First and foremost, I think it's important to recall the reasons you chose to elect S status for your business because these reasons are still very important and valid to consider.  Here are a few other reasons to remain an S corporation:

  • Avoid Double Taxation
    • With an S corporation, shareholder(s) avoid double taxation, meaning all the income earned, or losses incurred, including any credits, gains, interest or other deductions, is passed directly to the shareholder(s) and taxed at the shareholder income tax rate.
    • With a C corporation, the shareholder(s) are taxed twice, once at the corporate level on the earnings and again at the shareholder level on the dividends withdrawn from the corporation.  This is especially important if a company has plans to liquate the business in the future and expects to have significant gains.  The shareholder(s) will not only be paying corporate tax at 21% but again when the shareholder(s) liquidate their stock at the individual level.
  • Qualified Business Income (QBI) Deduction
    • A new provision from the TCJA allows a shareholder of a pass-through entity to claim a deduction up to 20% of qualified business income, whereas this deduction is not available to shareholders of C corporations.
  • Lower Pass-Through/Individual Income Tax Rates
    • The TCJA also enacted lower individual tax brackets reducing the highest bracket to 37% from 39.6%.  The lower individual income tax rates combined with the QBI deduction, can effectively lower the individual tax rate to 29.6%.
  • Reelecting S Status After Termination
    • Whether the termination was voluntary or involuntary, a corporation must wait 5 years before reelecting S status and that's if the company is still eligible to become an S corporation.  
  • Built In Gains Tax
    • Another issue with reelecting S status, is built in gains tax. A Company would need to wait another 5 years after reelecting S status before liquidating and recognizing income otherwise the company would still be subject to double taxation at the highest corporate rate, currently at 21%.

On the other hand, here are some factors that may make a C corporation sound more favorable.

  • Lower Tax Rate
    • Paying tax at the corporate flat tax of 21% instead of the maximum individual rate 37% on pass-through income, or effectively at a tax rate of 29.6%, mentioned above.  If the QBI deduction applied, the effective rate would still be higher than 21%. 
  • No Corporate AMT
    • The TCJA also repealed corporate AMT.  Although the exemptions at the individual level increased, there will likely be fewer taxpayers subject to AMT at the individual level.
  • Accounting Method Change
    • Since C corporations generally may not use the cash method of accounting, the newly converted C corporation will now be required to use the accrual method of accounting.  Along with filing Form 3115, Application for Change in Accounting Method, and requesting permission from the IRS to change methods of accounting, the company will need to recognize either additional income or expense as part of the accounting method change, aka a 481(a) adjustment.  If the 481(a) adjustment ends up being positive, i.e. additional income to recognize, the TCJA has allowed companies to spread this adjustment over 6 years instead of the normal 4 years.  Of course if the adjustment results in a negative adjustment the company can recognize the additional expense all in the year of change or elect to spread it over 6 years.  The new 6 year rule is only applicable to businesses that are now required to be on the accrual basis of accounting as a result of converting from S corporation to C corporation.   
  • Distributions Out of Accumulated Adjustments Account (AAA)
    • The TCJA provided some relief to help S corporations that voluntarily revoked their S election.  When an S corporation voluntarily revokes its S election, it has until the end of its PTTP** (post-termination transition period) to distribute previously taxed earnings, i.e. cash, and basis out of the corporation in a fully tax-free manner.  If the company's cash balance allows it, the company should consider a distribution to its shareholder(s) sufficient enough to eliminate the accumulated adjustments account (AAA) to avoid paying additional tax.  If AAA cannot be distributed before the PTTP ends, under new code Section 1371(f), "AAA will be allocated to the distribution, and the distribution will be chargeable to the corporation's accumulated earnings and profits (AE&P) in the same ratio as the amount of such AAA bears to the amount of such AE&P."  This is important because it allows former S corporation shareholder(s) to avoid dividend treatment, i.e. tax, on a portion of the post PTTP distribution.

**PTTP is the period beginning on the day after the S status termination and ending the later of (1) one year after the termination date, or (2) the due date for filing the final S corporation return (including extensions).

  • Tax-Free Fringe Benefits
    • As an employee/shareholder of a C corporation many fringe benefits are considered "tax-free" to the employee/shareholder and are still deductible by the company. In the case of an S corporation, owner fringe benefits are added back to the shareholder's W-2 and are taxed at the individual level.
  • Reaching S Corporation Shareholder Limits
    • S corporations are limited to 100 or fewer shareholders. If your company is approaching this limit or expects to in the near future, the lower corporate tax rate is a good incentive to convert.
  • Suspended Shareholder Losses
    • If a shareholder has disallowed losses in the last S corporation year because of insufficient basis, the shareholder can use these losses on the last day of the PTTP.  The losses aren't necessarily lost, the shareholder would have to wait a period of time to use them.

Above are just a few selected items to consider before converting to a C corporation. There are a number of other issues and points not discussed above to consider as well.  The decision to convert to a C corporation is not a one size fits all decision or analysis, there are many costs and benefits and various scenarios to analyze.  The analysis should include the specifics of your business and the future and potential growth you are expecting before converting to a C corporation. 

If you want to discuss converting to a C corporation further, please feel free to contact your Dermody, Burke & Brown tax advisor to discuss this and any other tax matter.

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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