TAX PLANNING | 08/08/2024
With key provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) set to expire at the end of 2025, many business owners are reassessing their entity structures. The expiration of the qualified business income deduction (Section 199A) and the reversion of individual tax rates in 2026 raise questions about the potential advantages of converting pass-through entities (S corporations or partnerships) to C corporations.
While the flat 21% corporate tax rate—made permanent by the TCJA—may seem attractive, careful consideration is required. Below are the top reasons why pass-through entities may not benefit from converting to a C corporation.
1. Pass-Through Tax Rates May Still Be Lower for Some Businesses
Pass-through entities offer the advantage of income being taxed at the individual level, often at rates lower than the 21% C corporation rate:
- Capital Gains: Individuals face a maximum 20% tax rate on capital gains, compared to the 21% corporate tax rate.
- Graduated Tax Rates: For lower-income individuals, portions of pass-through income may be taxed at lower individual rates (e.g., 10% or 15%), resulting in a lower overall tax liability compared to the flat 21% corporate rate.
2. Double Taxation on C Corporation Earnings
Unlike pass-through entities, C corporations face two levels of taxation:
- Corporate-Level Tax: Earnings are taxed at 21% at the corporate level.
- Shareholder-Level Tax: Dividends distributed to shareholders are taxed at up to 23.8% (20% capital gains rate + 3.8% net investment income tax).
When combining these rates, the total tax on distributed income can reach 39.8%, surpassing the 39.6% top individual marginal tax rate for pass-through income.
While Section 1202 exclusions may reduce taxes on certain C corporation stock sales, these exclusions have limitations, particularly for real estate and certain service businesses. Dividends paid by the corporation are not eligible for the Section 1202 exclusion.
Additionally, the accumulated earnings tax may apply if the IRS deems that retained earnings exceed the reasonable needs of the business, limiting the ability to defer shareholder-level taxes.
3. Challenges of Converting Back to a Pass-Through Entity
Converting to a C corporation is far easier than reversing the decision:
- Five-Year Waiting Period: Once an S election is revoked, the entity typically cannot re-elect S status for five years.
- Penalty Taxes: Returning to pass-through status may trigger penalty taxes, such as the built-in gains tax or the excess passive investment income tax, further complicating the process.
4. Cash Method of Accounting Restrictions
S corporations enjoy greater flexibility in using the cash method of accounting, especially if they do not maintain inventories. In contrast, C corporations must meet the gross receipts test under Section 448(c) to qualify for the cash method.
Switching to a C corporation may necessitate a change to the accrual method, resulting in:
- Unfavorable Accounting Adjustments: A Section 481(a) adjustment may create additional tax liabilities during the transition.
- Loss of Simplicity: The cash method is often more straightforward and advantageous for smaller businesses.
5. Uncertainty in Future Tax Legislation
While the 21% C corporation tax rate is permanent under current law, tax policies are subject to change:
- Political Shifts: Future legislation could raise the corporate tax rate, extend the Section 199A deduction, or introduce new tax provisions that alter the cost-benefit analysis of converting.
- Risk of Premature Action: Without greater clarity on post-2025 tax laws, converting to a C corporation now may lead to unforeseen disadvantages if legislative priorities shift.
Conclusion: Proceed with Caution
Converting to a C corporation may seem appealing due to the flat 21% corporate tax rate, but the double taxation on earnings, difficulty in reverting to pass-through status, and uncertainty in tax law make it a complex decision.
How Our Tax Consulting Firm Can Help
Our team specializes in helping businesses evaluate the tax implications of entity structures. We’ll work with you to:
- Analyze your specific financial situation and long-term goals.
- Assess the potential tax impacts of converting to a C corporation versus retaining pass-through status.
- Provide guidance on tax-efficient strategies tailored to your business.
Contact us today to explore whether a C corporation structure aligns with your business objectives and the evolving tax landscape.