The new tax laws have many businesses considering the benefits of C-Corp taxes in comparison to S-Corp taxes. Should they switch business entities to take advantage of the new tax rates? However, the tax consequences of converting S-Corp to C-Corp may surprise you. Read on to discover if switching from S-Corp to C-Corp makes sense for your situation.
What’s the difference between an S Corporation and a C Corporation?
S Corporations are “corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes,” according to the IRS.
A C Corporation “is a corporation in which the owners, or shareholders, are taxed separately from the entity. C corporations, the most prevalent of corporations, are also subject to corporate income taxation,” according to Investopedia.
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The main differences are with the ownership, shareholder rights, and taxation policies of these entities. C-Corps are taxed at the corporate level and on your personal tax returns if you distribute dividends to shareholders. The S-Corp has pass-through taxation, meaning it is only taxed at the personal level.
Why are S-Corps considering switching to C-Corps?
With the new Tax Cuts and Jobs Act making historic changes to the tax laws in the U.S. C-Corps had their corporate tax rate decreased from 35% to 21%! This has led to many questions from S-Corps if they should take advantage of a lower corporate tax rate and switch to the C-Corp entity.
3 reasons NOT to switch to a C-Corp entity
In theory this may seem like an obvious choice, but every business is unique and should be treated as such. There are definitive reasons it may not make sense to switch your entity – especially before consulting with a tax professional. Here are three examples.
- Your business location
- Your state tax has a large impact in addition to the federal tax rate. It wouldn’t make sense to submit to corporate state taxes willingly if they will increase your total taxation.
- Qualified business income deductions
- The new law may lower the corporate tax rate, but it also increased S-Corp deductions to 20% of qualified business income. The deduction qualifications have broadened, though there are still cases that will disqualify you. For example, tax code provision 199A is phasing out consulting firms, medical practices, and brokerage services from the deductions.
- Cash retention history
- Businesses who hold onto cash for expansion purposes and other reasons could be subject to some serious penalties as a C-Corp. The worst-case scenario is that the C-Cop stores too large an amount which raises a red flag to the IRS that you’re avoiding paying tax on dividend distributions. The IRS may hit you with a 20% penalty called the accumulated earnings tax.
What should you do?
Before making any major entity decisions in light of the tax reform, talk to a tax professional. There are no black and white answers for what to do, it really depends on your business. If you’re considering switching from an S Corporation to a C Corporation, contact Gift CPAs now to set up an appointment with one of our tax professionals!