Was the 2017 Tax Act needed? Will it help with capital expenditures and bank lending? And what about the S versus C Corp decision? Here’s what area experts have to say.
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To be or not to be an S Corp or a C Corp?
That is the question.
Recent tax law changes have many businesses asking their CPAs if they should remain an S Corp or switch to C Corp. Of course there is no black-and-white answer.
An S Corp passes most income or loss onto its shareholders who are responsible for reporting them on their individual tax returns (hence the term pass-through business).
In contrast, a C Corp files a federal form (1120) and pays tax due. Dividends or distributions to shareholders require shareholders to pay tax at their individual income tax rates, essentially leading to a double tax.
McFarland State Bank is an S Corp, and Chairman and CEO E. David Locke says the bank is currently weighing all the options.
“We have the ability and the right to switch [to a C Corp] if we choose. There is no ambiguity in C Corp rates being 21%, but the devil is always in the details, and we’ll have to see if Treasury will write the tax rules as they were intended.”
He looks forward to that day, arguing that businesses won’t make investments until they have clarity on the new rules of the game.
Kory Stoehr, CPA and tax partner at BDO’s Madison office, helps sort things through. “Prior to the Tax Act, one of the biggest issues with being a C Corp was the double tax,” he explains. A C Corp pays its own tax at a top rate of 35% and if dividends are paid out to shareholders, a second layer of tax gets paid by the individual shareholder at a federal rate of 23.8%.
A profitable S Corp, on the other hand, would get taxed at an individual federal rate — perhaps as much as 43.4% — but wouldn’t have a double layer of tax.
The new tax rules change that, Stoehr explains.
The C-Corp rate dropped from 35% to 21%, and the maximum individual rate went from 39.6% to 37%. “For some businesses, there is now a potential 16% difference between a C Corp’s rate and the S Corp shareholder’s rate,” he says.
In other words, on $100,000 a C Corp pays $16,000 less in tax every year. C Corps also are allowed to take deductions for state and local taxes, whereas the individual taxpayer has a limit of $10,000.
“This is where it can get complicated,” he warns.
With the new reform, S Corp or pass-through income may be eligible for a 20% reduction for qualified business income.
“Effectively that reduces the maximum rate of 37% down to an effective tax rate of about 29.6%, bringing the rate differential closer, but still higher than the C-Corp rate of 21%.”
However, C Corp dividends and passive shareholders of an S Corp also may be subject to the 3.8% net investment tax, which still exists, Stoehr cautions.
With S Corps, income or losses affect the basis in the event the company is sold.
“Say you pay $1,000 for C-Corp stock and $1,000 for S-Corp stock and you hold each for 10 years and in each of those years the stock generates $1,000 worth of income. As a C Corp, your basis in that stock is what you paid for it, so after 10 years, the basis is still $1,000. If you sell it for $10,000, your net gain is $9,000.
“On the other hand, if you’re an S Corp and paid $1,000 for the stock and it generates $1,000 in income over each of 10 years, that income increases your basis. So now your basis is $11,000 when you decide to sell and you’d potentially have a net loss.”
There simply is no one-size-fits-all answer when deciding between a C Corp or an S Corp, Stoehr insists. “It’s all facts-and-circumstances driven.”
A multi-generational family owned business, for example, with plans to pass stock from generation to generation may want to consider a C-Corp status.
“Although unlike an S Corp, the shareholders of a C Corp do not get a build-up of basis with annual taxable income generated at the C Corp,” he explains. “The heirs designated to receive the shares of stock, upon death, will receive a step-up in the basis equal to the fair-market-value of the stock at the date of death.”
On the other hand, if the plan is to sell the business in the future — depending on the type of sale asset versus stock — an S-Corp status could prove more beneficial.
“It’s all very complex and a multitude of variables (i.e. dividend policy, exit strategy, etc.) could ultimately impact your answer,” Stoehr states.
Only you and your tax advisor can make that determination.
“Until you model it out and get a true understanding, I wouldn’t advise anyone to make a decision simply based on the corporate tax rate,” he adds.
Meanwhile, Locke is weighing the rules carefully.
“In my opinion, we’re better off under a tax reform bill than we were without one, but if you think this is tax simplification, nothing gets simpler when it comes to the government.”
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