Should You Convert to a C Corporation: Weigh the Tax Consequences

The Tax Cuts and Jobs Act (TCJA) implemented major tax changes, including both permanent and temporary provisions. Relatively soon, the top federal income tax rate on pass-through business income is set to jump from 29.6% to 39.6%, while the C corporation tax rate is scheduled to stay at 21%.

Because of this change, you may be wondering whether it makes sense for your pass-through business to convert to a C corporation. Explore some pros and cons of converting as you develop tax-planning strategies for dealing with the impact of the TCJA sunset.

5 reasons to convert to a C corporation

1. Current cash tax savings

If you have high income, your business’s current federal income tax liability as a C corporation may be lower than as a pass-through business.

Example: Essco is an S corporation, and its shareholders are subject to tax at the highest tax rates. Essco makes $100,000 per year and distributes all its earnings.

Essco is considering a switch to a C corporation starting in 2026. These calculations compare the after-tax cash flow for Essco as an S corporation and as a C corporation:

	S corporation	C corporation
Income	$100,000	$100,000
Tax rate	39.6%	21%
Tax on income	$39,600	$21,000
After-tax cash flow for corporation	$60,400	$79,000

Essco can save $18,600 per year as a C corporation if it retains the earnings to finance expansion of its business.

As the example shows, corporations that reinvest earnings in the business and have high-income shareholders may reduce their current cash tax cost by operating as a C corporation.

As you evaluate your current structure, consider the shareholder tax on the C corporation’s earnings that may eventually apply when the corporation pays dividends or when stock is sold.

2. Possible gain exclusion under Section 1202

You may be able to avoid paying federal income tax on up to $10 million of gain (or 10 times your investment, if greater) from selling qualified small business stock under Section 1202.

Buyers often insist on buying a corporation’s assets so they can claim additional depreciation deductions. In that case, a corporate-level tax on gain from the asset sale would apply, reducing or eliminating the benefit of the gain exclusion.

A discussion of the qualified small business stock requirements is beyond the scope of this article, but you should know the gain exclusion is available only if you acquire stock directly from the business while it’s a C corporation. Stock issued while the corporation was an S corporation doesn’t qualify for the exclusion, even if the company subsequently converts to a C corporation.

3. Enhanced access to capital

To qualify as an S corporation, your business needs meet the following requirements, among others:

• Only one class of stock
• No more than 100 shareholders
• Shareholders must be U.S. individuals, certain trusts, or estates (i.e., no corporations, partnerships, certain trusts, or non-resident aliens)

C corporations aren’t subject to these restrictions, which can limit your company’s ability to raise capital and issue stock to employees. For example, if a venture capital fund organized as a partnership invested in your S corporation, your S corporation would lose its S corporation status. Also, if your business has a non-resident employee or a large workforce, you may not be able to include everyone you want in the ownership group.

Partnerships are generally more flexible than S corporations; regardless, certain investors — including foreign and tax-exempt investors — are subject to additional tax reporting if they invest in a partnership and may insist on investing in a C corporation.

4. Simplified tax reporting for owners

Owning a pass-through business may result in tax reporting challenges that wouldn’t apply if it were a C corporation:

• Paying estimated taxes on your share of business income
• Filing tax returns in each state where the business has operations
• Including pass-through business income in your personal tax return
• Tracking your basis in the business
• Complex health insurance reporting

These burdens of operating a pass-through business are multiplied if your business has several owners.

5. Expanded employee benefit offerings

There are limits on obtaining certain tax-free benefits from your pass-through business, including group-term life insurance, cafeteria plans, and adoption assistance programs. Thus, a C corporation provides more flexibility to obtain tax-free fringe benefits.

5 reasons not to convert to a C corporation

1. Double tax may erode any tax savings

C corporations are subject to two tax levels:

• The C corporation pays a 21% corporate tax on its income.
• Shareholders pay up to 23.8% federal tax on dividend distributions from the C corporation or capital gains from the eventual stock sale.

Your pass-through business is generally not subject to an entity-level tax. Instead, the business income passes through on a Schedule K-1 and is taxed on your personal return. Distributions you receive from your pass-through business are generally tax free.

As the following example illustrates, the second level of tax on distributions from a C corporation can offset the tax savings from the lower tax rate on business income in some cases.

Example: Essco is an S corporation and its shareholders are subject to the highest tax rates. Essco makes $100,000 per year and distributes all its earnings. Essco is considering a switch to a C corporation after the TCJA is scheduled to sunset.

	S corporation	C corporation
Income	$100,000	$100,000
Tax rate	39.6%	21%
Tax on income	$39,600	$21,000
Taxable dividend	$0	$79,000
Tax rate	0	23.8%
Shareholder dividend tax	$0	$18,802
After-tax cash to shareholders	$60,400	$60,198

While the tax on Essco’s business income is lower as a C corporation than an S corporation ($21,000 vs. $39,600), the after-tax cash available to the Essco shareholders after paying the shareholder dividend tax is actually lower as a C corporation than as an S corporation ($60,198 vs. $60,400).

2. Tax rates may be lower for some pass-through businesses

If you are actively involved in your pass-through business, your federal capital gains rate generally would not exceed 20%, which is lower than the 21% corporate tax rate. If you expect to generate significant capital gain (e.g., from the sale of goodwill in an asset sale), you may prefer a pass-through structure.

C corporations are subject to a flat 21% tax rate. In contrast, individual tax rates can be as low as 10%. Depending on your level of personal income, the effective federal income tax rate on your pass-through business income may be less (or not much more) than the 21% C corporation tax rate.

3. Uncertainty with future tax law

While the 21% tax rate is considered permanent, so was the 35% corporate tax rate before the 2017 tax reform bill. There really are no permanent tax rules.

The calculus of converting to a C corporation will change dramatically if Congress raises the corporate tax rate, reduces pass-through business taxes, or enacts other significant tax legislation.

4. Difficulty converting a C corporation back to a pass-through entity

Converting your business to a C corporation is much easier from a tax perspective than converting back to a pass-through entity. For example, if you revoke your company’s S election, the corporation generally cannot convert back to an S corporation for five years. Even then, the S corporation may be subject to certain penalty taxes following the conversion back to an S corporation.

In many cases, it won’t make sense to make a hard-to-reverse decision to convert to a C corporation until there is more certainty about tax laws in the coming years.

5. Restrictions on the cash method of accounting

If your pass-through business doesn’t have inventory, it can generally use the cash method of accounting regardless of its revenue. However, a C corporation generally may not use the cash method if it has more than $30 million in average annual gross receipts.

The cash method of accounting is generally more favorable than the accrual method, so you should consider the effect of a conversion on your ability to use the cash method.

How CLA can help you consider a C corporation conversion

While the flat 21% corporate tax rate may tempt you to consider converting your business to a C corporation, the decision should not be made lightly. The potential tax savings must be weighed against the possibility of double taxation, future tax law changes, challenges of reverting back to a pass-through entity, and limits on using the cash method of accounting.

Our tax professionals can model your business’s after-tax cash flow as a C corporation and as a pass-through entity, providing custom evaluation to help you make informed long-term decisions.

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