Should I Convert My Pass-through to a C Corporation?

Many of the more favorable aspects of the Tax Cuts and Jobs Act of 2017 (TCJA) are scheduled to sunset at the end of 2025 — like the expiration of the qualified business income deduction under Section 199A and the reversion of individual tax rates in 2026.

The C corporation tax rate, which was permanently changed to a flat 21% from a previously graduated rate structure with a top rate of 35%, will not sunset. This has led to many recent questions on entity conversions.

On the surface, the lower tax rate might make C corporations look more attractive than S corporations, but careful consideration should be given, especially in our ever-changing political and regulatory environment.

Top 5 reasons why pass-through businesses should not convert to a C corporation

1. Tax rates may be lower as a pass-through for some businesses

The capital gains tax rate of up to 20% that is applicable to individuals is lower than the corporate tax rate of 21%. Businesses that expect to generate a significant capital gain may prefer a pass-through structure. Furthermore, for lower-income individuals, the tax on their pass-through income with the graduated tax rates, including income taxed at 10% and 15%, may be lower than the 21% tax on C corporation earnings.

2. Double tax applies to C corporation earnings

S corporations are generally not subject to an entity-level tax. Instead, an S corporation’s income flows through to its shareholders and is taxed at the shareholder level. Unlike S corporations, C corporations are subject to two levels of income tax:

• First, the C corporation pays tax on its taxable income at the corporate level
• Then, the shareholders pay tax on dividend distributions from the C corporation

Most dividends are also subject to the 3.8% net investment income tax (NIIT). Therefore, the tax rate on C corporation dividends of top earners will generally be 23.8%, which is composed of the 20% capital gains tax rate on qualified dividends plus the 3.8% NIIT.

When the 23.8% rate is applied to the 79% of C corporation income remaining after the 21% corporate level tax is paid, the total tax rate on the distributed C corporation income is 39.8% [21% + (23.8% x 79%)], which is higher than the 39.6% top marginal tax rate applicable to an individual S corporation owner.

In some cases, the Section 1202 qualified small business stock gain exclusion reduces or eliminates the second level of tax on gain from the sale of the stock if the requirements are met. The ability to use Section 1202 for real estate entities is severely limited; certain businesses, including leasing, brokerage, and hotel/motel operation businesses, are ineligible for the exclusion. Further, the Section 1202 exclusion does not apply to dividends paid by the corporation.

Most C corporations retain some portion of their earnings for use in the business, which will only be subject to the 21% tax until distributed. Thus, C corporation owners can benefit from deferring the tax on the dividends.

However, the IRS may assess the 20% accumulated earnings tax on C corporation accumulated taxable income for the tax year in excess of the amount retained for the reasonable needs of the business, which would limit the ability to defer the shareholder-level tax unless there is a business need to accumulate earnings within the company.

3. Difficulty in converting from a C corporation back to a pass-through

Converting to a C corporation is much easier from a tax perspective than converting back to a pass-through entity. If an S corporation revokes its S election, it cannot typically re-elect S status for five years. Even then, the S corporation is subject to certain penalty taxes, such as the built-in gains tax and the excess passive investment income tax, following the conversion back to an S corporation.

4. Restrictions on cash method of accounting

S corporations that do not maintain inventories and are not considered tax shelters may generally use the cash method of accounting regardless of gross receipts. But a C corporation generally may not use the cash method if it does not meet the gross receipts test of Section 448(c).

Consequently, a conversion to a C corporation may require a change in the corporation’s overall method of accounting and a potentially unfavorable accounting method change and Section 481(a) adjustment.

5. Uncertainty surrounding future tax law

The political landscape is uncertain, and the tax law may change before the TCJA sunsets. While the 21% tax rate is “permanent,” so was the 35% corporate tax rate prior to the enactment of the TCJA.

The calculus of converting to a C corporation will change dramatically if Congress raises the corporate tax rate, extends the Section 199A deduction, or enacts other significant tax legislation. In most cases, it does not make sense to convert to a C corporation without more clarity on future tax legislation.

A big thank you to our national tax office for their assistance with this blog post!