If you look at the TCJA, you will see that the C Corps' new tax rate is 21%, while the maximum individual rate is 37%. Also, individuals can benefit from a 20% deduction for pass-through income. Considering these principles, many taxpayers wonder if they should convert their pass-through business, like an LLC, partnership, and S corporation, to a C corporation to take advantage of the lower flat rate.
While this conversion may be beneficial for some, the decision is complex and tailored to their specific business activities. We will explore some of the concerns related to the difference in the tax treatment of pass-through and C corps under the new law and if a C corp conversion is a good idea.
TCJA Business Rate review
TCJA reduces the corporate tax rate from 35% to a flat rate of 21% without brackets from 2018. It also repeals the AMT. Although the law makes notable changes to the treatment of partnerships, corporations, and S corporations, there is no maximum fee for the pass-through company. On the other hand, the new law reduces the maximum individual rate to 37% and allows a 20% deduction for pass-through income. Combining these two tax provisions leads to a maximum tax rate of 29.6% for pass-through income. The individual AMT is maintained, but the exemptions are increased so that more taxpayers can avoid it. Company and pass-through discounts are permanent, while individual provisions are only temporary and expire after 2025. Against this background, below are some of the issues with converting to a C Corp.
Businesses continue to pay double taxes.
Although the 21% corporate tax rate is potentially lower than the 29.6% income rate, companies continue to pay taxes at two levels, the entity level and the shareholder level. The entity pays an income tax of 21%, and shareholders pay 0% to 20% of dividends paid, depending on their income level. Dividends are also subject to a net investment income tax of 3.8% if the adjusted gross taxpayer income (AGI) exceeds $ 200,000 for singles or $250,000 for joint filers. Therefore, corporate double taxation reduces the differential rates between C corporations and pass-throughs.
However, if your long term business plan is not to pay dividends, the C Corporation might be more beneficial. Profits reinvested in businesses are not taxed twice, so a lower business rate and increased business value may be a better choice for owners. However, beware of the C Corporation accumulated income tax, a 15% tax on profits held in the business beyond its reasonable needs.
Also, note that businesses can deduct all state and local taxes, but individuals are subject to the new limit of $10,000 for all state and local taxes combined. This rule favors C Corporation.
Sole proprietors may consider incorporating to protect part of their income from higher individual rates, 37% for individuals, but only 21% for businesses. This strategy can work well if the owner has the flexibility to schedule dividend payments for short years.
Fringe Options for C Corps
C corps traditionally has access to more advantageous tax fringe benefits than pass-throughs, especially for owners. More than 2% of pass-through holders cannot exclude most fringe benefits paid by the company, including group life insurance costs, health or accident insurance plans, meals, and accommodation provided for the employer's convenience. On the other hand, C Corporation can deduct the costs of medical insurance for owner-employees, life insurance plans, employee-owned vehicles, long-term care plans, etc., and has several options for retirement plans. Employees of C corps enjoy these tax-free benefits.
Advantages and disadvantages of pass-through
Deducting the 20% pass-through based on TCJA is not a sure thing. The law provides complex anti-abuse rules that limit the availability of the deduction based on income level, type of business, the value of salary paid, and the value of the depreciable property the business owns. For professional service firms, such as investment firms, law firms, and accounting firms, the full deduction is not authorized unless the owners' taxable income is less than $157,500 for individuals and $315,000 for joint filers. Suppose a taxpayer exceeds these income levels, the deduction decreases as income increases. It is completely lost when the taxpayer reaches $207,500 in taxable income for single taxpayers and $ 415,000 for joint filers. When a taxpayer reaches these maximum limits, the income stream is fully taxed at individual rates of up to 37%. (Please note that engineering and architectural firms are not subject to professional service limitations.)
For non-professional taxpayers, deduction restrictions can be avoided if they have high W-2 salaries or large depreciable assets.
In this context, a key planning point regarding the new tax system is: If you are below the income limit of $ 157,500/$ 315,000 for pass-through deduction limits, you do not need to convert to a C corporation. Suppose your income exceeds these levels, and your business has low W-2 wages and few depreciable assets. In that case, there may be a tax advantage to becoming a C corporation as you are unlikely to take full hold of the 20% deduction.
Additionally, for C corps, the losses are not passed on to the owners, while the owners can use the entity's losses to offset other income from their returns. This factor favors the pass-through entity.
Conversions can be expensive and difficult.
Depending on the amount of tax you can save, it may not be worth converting to a C corporation. It can be time-consuming and costly to convert to a C corps under state laws if you are an LLC or a partnership. S corporations can revoke their status and become C corporations if the majority of shareholders agree.
Another issue is when (if you choose to revert) your business wants to revert to a pass-through entity again. State procedures can be complicated, and the IRS will not allow a new S election for five years for S corps. Therefore, for logistical reasons, the decision to change the business entity cannot be made easily and must be taken as part of a careful long-term plan.
Conclusion
As you can see from the discussion above, the issue of converting your business into a different entity under the new tax law is complex. For each benefit presented, there are caveats. Moreover, tax considerations are not the only factor. While there are many free tips on restructuring under the TCJA, the solutions presented are not for everyone. Careful analysis of your business and long-term goals is necessary to select the right option. You should hire tax specialists and business consultants to make sure you take the right steps, if necessary.
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