By Lance Christensen, CPA
Current tax reform proposals put forth by the incoming Trump Administration and the Republican House of Representatives would greatly reduce tax rates on businesses – and could make those set up as C-Corporations rethink their choice of entity structure. Under current U.S. federal income tax law, a C-Corp is a corporation that is taxed separately from its owners, which has traditionally not benefitted small business owners. Many small business owners have opted instead to elect S Corp status for their corporations or set themselves up as limited liability corporations (LLCs).
Over the next year, however, this might change. After all, the proposed tax rate reductions could turn out to be the largest tax rate reduction in U.S. history. The change may motivate many companies who are currently structured as “S-Corporations” to terminate that election. Under the current structure, an S corporation is a special type of corporation created through an IRS tax election. An eligible domestic corporation can avoid double taxation – once to the corporation and again to the shareholders – by electing to be treated as an S corporation.
How C-Corps May Become a Small Business Advantage
As the tax laws now stand, there are quite a few disadvantages to the current C-Corp structure, which is why it is not very popular with many businesses. Historic disadvantages of C-Corps include:
- C-Corp status imposes two levels of taxation on the same income
- First, at the entity level when the income is earned
- Second, at the individual level when the corporation distributes the income to its shareholders (dividends)
- Many of them are required to use an accrual basis of accounting (no cash basis)
- The Alternative Minimum Tax sets a limit on how many tax benefits C-Corps can receive
But if President Trump’s proposal goes through, a reduction in the corporate tax rate to 15 percent may incentivize new small businesses to elect C-Corp status at the time of formation – and may even also result in convincing certain existing S-Corps to switch their status.
Electing a Status
To become an S-Corp, a business must elect this status with the IRS. S-Corps have grown popular over the years because of their tax structure; however, they also have their drawbacks. For example, S-Corps are limited in the type and number of shareholders they can have. There are several other restrictive provisions imposed on S-Corps making them less flexible when compared to other types of entities such as partnerships. Still, the majority of small (and mid-size) businesses founded in the past two-plus decades have formed as S-Corps (or LLCs).
Per the proposed tax plan by President Trump, corporate income tax rates would be lowered from 35 percent to 15 percent. Currently, the highest corporate income tax rate is 35 percent and the highest individual tax rate on qualified dividends is 20 percent.
Note that the tax reform proposals also contain provisions that would dramatically change the way S-Corps and partnerships (and their shareholders and partners) are taxed.
Considering the expected lower rates, it’s easy to see why companies may want to switch to C-Corp status. C-Corps already have many built in advantages for small businesses. They deduct amounts paid for fringe benefits for employees and owners, and allow for an unlimited number of business owners. Additionally, while S-Corps must use a calendar year for their financials, C-Corps can elect a fiscal tax year.
If Trump and Congressional Republicans are successful in reducing corporate income tax rates, it would have the effect of making the benefits attractive enough for some businesses to change their status.
How can business owners plan for the future, today:
Changing the structure of a small business is a decision that should be weighed carefully. The C-Corp and S-Corp models have their advantages and disadvantages, and legislation can shift these at any time.
While there is no denying the potential that lies ahead for C-Corps, it’s far from a certainty that any of the tax proposals will become law. Even if legislation does change and a business elects to switch from an S-Corp to a C-Corp, the corporation generally would be restricted from re-electing S-Corp status for several years.
Lance Christensen is a partner with Margolin, Winer & Evens, one of the largest accounting and business advisory firms in the Northeast. A well-recognized expert in various taxation matters, he is a frequent speaker on timely tax-related topics. To be proactive and to prepare for any legislative changes in the future, contact us to weigh your options.