By Jennifer Kobylarz, CPA, MST
Recent guidance by the IRS specifically addressed conversion of an S corporation to a C corporation, which has left a lot of business owners wondering if a change would be beneficial. The Tax Cuts and Jobs Act of 2017 (TCJA) lowered the top federal tax rate on a C Corporation from 35% to 21%. With all the feedback we have received, we feel this would need to be evaluated on a case by case basis; however, we wanted to provide some insight to address these options.
The new guidance addressed the issue of double taxation: tax at the corporate level and individual level.
To convert:
- An S corporation would need to revoke their S-election
- (Potentially) file a change in accounting form (IRS Form 3115)
- Distribute out ALL of its Accumulated Adjustments Account (AAA) by December 31, 2019 to shareholders
- AAA is the retained earnings inside the S corporation that have been previously taxed at the shareholder level. Any amounts not distributed from AAA by December 31, 2019 are now deemed dividends starting January 1, 2020, and are subject to double taxation.
The IRS added section 199A deduction of 20% on pass-through income for qualified business income as a way to assist in “leveling the playing field” in tax rates between C and S corporations. Entities that fall under the umbrella of “specified service trades and businesses” meaning any trade or business involving the performance of services in the fields of health, law, accounting, etc. to name a few, do not get this pass-through deduction if the income levels at the shareholder level are too high. These S corporation entities may be candidates for conversions to C corporations, and again, should be considered on a case by case basis.
Post December 31, 2019, profits would be taxed assuming a top tax rate of 21% which would be paid by the C corporation. Any monies paid out to owners in the form of dividends (one of the only ways to get cash out of a C corporation, ignoring wages or other compensation which can be taxed as high as 37%) would be at taxed on the
individual level at 20% or 23.8%, if not active in that entity. Additionally, corporate state tax rates would apply to profits as well. This may have not been the case previously, such as in Florida, where there is no state tax on S corporation income at the individual level.
The IRS added section 199A deduction of 20% on pass-through income for qualified business income as a way to assist in “leveling the playing field” in tax rates between C and S corporations. Entities that fall under the umbrella of “specified service trades and businesses” meaning any trade or business involving the performance of services in the fields of health, law, accounting, etc. to name a few, do not get this pass-through deduction if the income levels at the shareholder level are too high. These S corporation entities may be candidates for conversions to C corporations, and again, should be considered on a case by case basis.
Post December 31, 2019, profits would be taxed assuming a top tax rate of 21% which would be paid by the C corporation. Any monies paid out to owners in the form of dividends (one of the only ways to get cash out of a C corporation, ignoring wages or other compensation which can be taxed as high as 37%) would be at taxed on the
individual level at 20% or 23.8%, if not active in that entity. Additionally, corporate state tax rates would apply to profits as well. This may have not been the case previously, such as in Florida, where there is no state tax on S corporation income at the individual level.
The IRS added section 199A deduction of 20% on pass-through income for qualified business income as a way to assist in “leveling the playing field” in tax rates between C and S corporations. Entities that fall under the umbrella of “specified service trades and businesses” meaning any trade or business involving the performance of services in the fields of health, law, accounting, etc. to name a few, do not get this pass-through deduction if the income levels at the shareholder level are too high. These S corporation entities may be candidates for conversions to C corporations, and again, should be considered on a case by case basis.
