Today I am going to talk to you about tax classification for your business under the new tax laws. One of the questions that I'm being asked a lot right now is, "Should I take my S Corporation and revert back to or become taxed as a C Corporation?" And that's a very complicated question with a lot of variables. But I'm going break it down in general for us here today.
For many, many years, in my opinion, the United States lagged behind most of the world and that our corporate tax rates topped out at 35%. There was alternative minimum tax for corporations and the tax brackets were very narrow. So as a C Corporation or a traditional corporation without any further tax election, you would get to the top tax rate very quickly and could potentially have double taxation on your corporate earnings as well as the salary and dividends that you pay yourself out of that business.
The C Corp became a very undesirable structure when S Corporations came along, when that option came along back in the '80s. But, the game has changed because under the new tax law, the corporate tax rate has been set at a flat 21% for good. The corporate alternative minimum tax has been done away with. The playing field has been leveled. So the question that I'm getting is, "Should my S Corp really be taxed as a C Corp to be more advantageous?" And again, there are lot of variables here, but in general, these are some of the observations and thoughts that I'm having.
As an S Corporation shareholder, as you know, you're taxed on your pro rata share of the corporation's profits for the year. Your individual effective tax rate may be much higher than 21%. So that would seem like a good reason to switch over, right? Better effective tax rate at the corporate level. But here's something that we also have to take into account. Under the new tax law, most businesses will qualify under Section 199, for an exemption, on roughly 20% of the taxable income of that flow-through business, that S Corporation. Of those earnings, 20% of those may be tax free if you are in a qualifying business. That changes things a lot because now your effective tax rate as a shareholder just got lower. You may be below 21% now.
So what seems like a great idea on the surface may not work out that way based on some of the new law changes. We still have the double taxation problem with C Corporations. And that, as a stockholder, you're taxed on dividends paid by that corporation usually at 15%. Not always. You are also taxed on any salary you may draw at your ordinary income tax rate. The profits of that business are not flowing through to you anymore. And they will be taxed at a 21% flat rate. This means, unlike some people who were coming out in January saying that you needed to spin off business segments and you needed to restructure everything, now we have had a little more time to process this and do some deeper analysis. I recommend sitting down with your CPA and asking them the question, "Should my business remain taxed as an S Corporation? Or should I look at going to a corporate tax setting as in a C Corporation?" If you do make that decision however, you also need to keep in mind that the IRS will not just allow you to switch back and forth freely every year. There are some potential taxes and penalties for changing to and from a C Corporation too often.
So again ... And if you were a C Corp before, there is another consideration there as well if you went from a C Corp to an S Corp and back to a C Corp ... So while it is not possible to take a deep dive into the details right now, it is truly a case-by-case basis and there is no one better person than your CPA to sit down with you, walk through the variables, and determine what works out best for you. You also have to remember, what might work out best in one year may not work out best in the year after or the year after.
Another careful consideration should be, "What is my next five years going to look like? Am I selling my business? Am I trying to grow my business? Am I going keep my business the same?" And you also have to consider personal tax situations as well. If you are going to be selling a piece of property unrelated to your business, you are going to be taxed on that on a personal level which could certainly have an effect on whether it makes sense to go from an S Corporation to a C Corporation.
So again, I recommend sitting down with a CPA who is more than capable of helping you go through this analysis with real numbers and coming up to an answer that is going to work best for you.
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