NH Legal Perspective: Think twice before jumping on the C corporation bandwagon
By PETER BEACH
The new tax act reduces the tax rate for so-called C corporations (any corporation that does not elect to be taxed as an S corporation) to a flat rate of 21%.
That has a lot of people who operate businesses as sole proprietorships and pass-through entities (partnerships, S corporations and LLCs taxed as partnerships) thinking about whether they should incorporate to take advantage of the 21 percent rate, which is now significantly lower than both the highest rate for individuals (37 percent) and the highest effective rate for qualified business income from pass-through entities (29.6 percent).
On its face it might look like a no-brainer, but before jumping on the bandwagon consider these issues.
-- Do you use your business income to live on?
If you need most of your business income to live on, converting to a C corporation is probably not for you. The benefit of the 21 percent tax rate is only available to the extent the income is retained in the corporation.
If the corporation pays you compensation, it gets a deduction and therefore pays no tax on that amount. But you would pay tax on your compensation at the higher individual income tax rates, which puts you back where you were in the first place.
To the extent the corporation distributes the income as dividends, the corporation would get no deduction and so would pay tax at 21 percent.
In addition, you would pay tax on the dividends you receive at the qualified dividend rate (20 percent), for an overall double-tax rate of 36.8 percent.
-- Can you leave profits in the corporation?
If the C corporation were profitable enough to allow you to retain profits in the corporation and truly benefit from the 21 percent rate, you might still have to navigate the minefield of anti-abuse provisions to keep from losing the tax benefits of converting to a C corporation, including the economic substance and assignment of income doctrines, the accumulated earnings tax, the personal holding company tax and anti-abuse regulations that may be promulgated under the new tax act.
-- Is your effective individual tax rate lower than the corporate rate?
Just because your individual taxable income is subject to tax in a rate bracket that is higher than 21 percent does not mean that the corporate rate will be lower for you. Because the benefit of paying tax at a lower rate is retained as you rise through the brackets, you still benefit from the lower rates.
In fact, individual taxable income for joint filers of about $332,000 is taxed at an effective rate of 21 percent, even though that level of income is listed in the 32 percent bracket.
If you are operating a business as a sole proprietorship or pass-through entity and you don't qualify for the new 20 percent qualified business income deduction and you are in the 10, 12, 20 or 24 percent individual tax bracket, your effective tax rate is already 21 percent or less.
The top of the bracket for the 24 percent rate is taxable income of $315,000.
-- What if the tax rates change?
Given the political underpinnings of the new tax law and the volatile nature of politics these days, another matter to consider is what would happen if the relative tax rates for C corporations and individuals reverted back to something closer to their 2017 levels.
Although it is generally easy to convert a pass-through entity or sole proprietorship to a C corporation, converting back would trigger a tax on the unrealized appreciation in the business's assets.
Even the alternative of simply converting the C corporation to an S corporation would be problematic - not only would the corporation not be free from double taxation on the net built-in gains in its assets for five years, but even after the five years had passed a distribution of appreciated property, whether in liquidation or otherwise, would be subject to tax computed at the corporate level and passed through to the individual.
This is a tax you would not have had to pay at all if you had never converted to a C corporation.
Other issues to consider before you change your sole proprietorship or pass-through business to a C corporation include whether you want to give up (i) your ability to deduct the entity's losses against your individual income and (ii) the possibility that a buyer of your interest may pay a premium for a step-up in basis in the assets of the proprietorship or entity.
Neither of these tax benefits are available to C corporations. So it is clear that converting to C corporation status will not be beneficial for every taxpayer but it will be for some.
And because not every business is the same, the decision regarding conversion from pass-through or sole proprietorship status to C corporation status should be carefully considered with your tax adviser.
NH Legal Perspective is a biweekly column sponsored by Sheehan Phinney Bass & Green PA. This column does not provide legal advice. We recommend that you consult an attorney for specific guidance on legal questions.