December 2017’s Tax Cuts and Jobs Act has brought the most sweeping federal tax reform in over 30 years. Most firms and their advisors will spend a lot of time in 2018 sorting through the new rules, patiently waiting for guidance on how to apply them. While the general feeling is that the new tax legislation is taxpayer friendly, everyone’s situation is unique, and an in-depth review will be necessary to figure out how the rules impact your position and more importantly what steps you should take to maximize your benefits.
S Corporation vs. C Corporation
On the top of many firms’ lists will be the question of S Corp vs. C Corp. Over the years, the vast majority of firms have chosen to be taxed as S Corp. to gain the benefits associated with pass-through entities. S Corporations do not pay federal or state income taxes at the company level, but instead, allocate their taxable income to their owners who pay the taxes with their individual income tax returns.
C Corporations pay company level income taxes. Should the C Corporation then distribute previously taxed earnings to their stockholders, the stockholders pay a second layer of taxes again on their personal returns. Distributions from an S Corp. are not subject to this second layer of tax. While there are many factors to consider in the S vs. C decision, this avoidance of double taxation has always been a driving factor for organizing as an S Corporation.
With the passage of our new tax legislation that decision is now slightly more difficult. In our prior tax rate structure, individuals paid their federal taxes over a blended seven bracket system with a top rate of 39.6% while corporations paid at rates up to 35%. Coupled with the second layer of taxation on C Corporation distributions, this small differential in rates didn’t justify C Corporation status in most situations.
The Tax Cuts and Jobs Act reduced federal tax rates across the board, but the reductions were far more extreme for C Corps. C Corporations no longer pay taxes over a tiered system. All income under a C Corporation is now taxed at the very attractive flat rate of 21%. While individual rates have also declined, we still have seven brackets with a top rate of 37%.
All Things Considered
The differential between 21% and 37% is certainly attracting a lot of people’s attention. However, before you pull the trigger on switching to a C Corporation, there are MANY more things to consider. These include:
- While 37% is the top federal individual income tax bracket, the threshold for this bracket is high, and much of your income will be taxed at far lower rates.
- The new law also created a partial exemption from taxation for certain S Corporation income. Under the new provisions of Code Section 199A, many S Corporation stockholders will be able to exempt up to 20% of their S Corp. income from taxation.
- Architects and engineers were identified explicitly as qualifying for this powerful deduction. This means that even if you are in the 37% tax bracket, your effective rate will only be 29.6% (37% x 80%).
- The second layer of taxation still exists for C Corporations. If your firm commonly distributes a high percentage of its earnings to the stockholders, the combined federal rate will likely still be higher as a C Corporation.
- Don’t forget state income taxes. In some States, C Corporation rates remain significantly higher than their individual rates.
These are just a few of the considerations when making the S Corp. vs. C Corp. decision. There are many more, and before moving forward, you should weigh all factors and make a thoughtful analysis.
The Tax Cuts and Jobs Act certainly didn’t bring us tax simplification, but it did bring us the opportunity to plan and strategize to maximize future tax savings. Stay informed as new details develop. Register today for our next quarterly State and Local Tax Update, a 30-minute webinar highlighting the recent state and local tax changes that impact firms across the country.