There are many scenarios in which a business leader might reevaluate a company’s corporate tax structure, including tax planning purposes, planning for growth, or seeking investment.  We have found that many of our business clients are currently reassessing the choice between structuring their businesses as a Subchapter S Corporation (S Corp) or a C Corporation (C Corp) as a direct result of the recent November U.S. elections.

The current Congress does not need to act to maintain the corporate tax rate at 21% and has signaled its intent to reinstate the benefits of the Tax Cuts and Jobs Act (TCJA), including a 20% deduction for S Corps. This decision may have significant implications for your business. In many cases, this election to be treated as an S Corp can be made retroactively to the beginning of the year. Below are important considerations that business leaders should weigh in reevaluating corporate tax structure.  

Advantages of Converting to a C Corporation

1. Corporate Tax Rate vs. Individual Tax Rates
   • Flat Corporate Tax Rate: Corporations are currently taxed at a flat 21% rate, which is expected to remain in effect even after the TCJA provisions sunset in 2025, unless Congress raises the rate.
   • Exemption from Net Investment Income Tax (NIIT): The 3.8% NIIT does not apply to non-passive dividends received by shareholders.
2. Retained Earnings
   • Businesses that retain earnings for operational purposes may defer shareholder-level taxation on corporate earnings until dividends are distributed.
3. Depreciation Benefits
   • Bonus Depreciation: Corporations can utilize bonus depreciation deductions for equipment purchases, reducing the effective corporate tax liability under the 21% rate until the sunset provisions take effect.
   • Consideration of Losses: Excess deductions may result in unutilized losses if they surpass corporate taxable income.
4. Fringe Benefits
   • Broader Deduction Scope: Corporations can deduct more fringe benefits for shareholders owning more than 2% of the company.
   • Tax Treatment: While certain benefits like health insurance, group-term life insurance, HRAs, and FSAs are taxable as wages for shareholders, they are excluded from income if paid by a C Corp.
5. Section 1202 Gain Exclusion (Qualified Small Business Stock)
   • Gain Exclusion for Stock Sales: Shareholders of qualifying corporations may exclude gains up to $10 million, or 10 times their basis, upon selling shares.
   • Steps to Qualify: Corporations converting from S Corps must issue new shares and meet specific requirements.
   • Eligibility Limitations: Exclusions generally do not apply to businesses providing personal services (e.g., legal, medical, consulting) or those with over $50 million in gross assets. A 5-year holding period is required from the issuance of new shares.

Disadvantages of Converting to a C Corporation

1. Double Taxation on Dividends
   • Second Level of Taxation: Shareholders of C Corps face double taxation on dividends, increasing the effective tax burden, particularly for passive shareholders.
   • Non-Passive Shareholder Benefits: Non-passive shareholders may qualify for the lower preferred dividend tax rates (15-20%) and avoid the 3.8% NIIT.
   • Comparison to Individual Rates: Even with double taxation, non-passive shareholders might experience a slightly lower combined tax rate (36.8%) compared to the top individual rate (37%).
2. No Pass-Through Losses
   • Losses in a C Corp are not passed through to the shareholders because C Corps and their shareholders are treated as separate taxpayers.
   • Netting: If a combined group of pass-through entities has historically netted losses from separate entities, conversion to a C Corp may trap the losses of each C Corp, resulting in a 21% tax for certain entities and no loss allocation from the others.
3. Loss of Section 199A Deduction
   • Pass-Through Deduction: S Corps can qualify for the limited 20% pass-through deduction under Section 199A, which is unavailable to C Corps.
4. Cash Basis Accounting
   • Restrictions on Cash Basis: C Corps face more stringent requirements to qualify for the cash basis method of accounting compared to S Corps.
5. State Tax Issues
   • State-Level Double Taxation: Many states impose double taxation on C Corp earnings, potentially negating federal tax benefits for shareholders in those states.

These factors can significantly impact a business’s financial health, growth potential, and operational complexity, making the decision between a C Corp and an S Corp a critical one for business leaders.  It’s always best practice for a business leader to consult with the company’s tax professionals regarding the business’s particular circumstances in order to make an informed decision about which corporate tax structure best aligns with financial and operational goals.

For more detailed guidance, please feel free to reach out to our corporate and small business tax team.