Comparing the Effects of Tax Reform on C Corporations and S Corporations
In the wake of the recent tax reform legislation, many business owners are reevaluating the structure of their organization and questioning whether it would be beneficial to convert from a C corporation to an S corporation, or vice versa. The following is a review of the two structures and the breakdown of the changes.
A C corporation (“C corp”) is simply a standard corporation and is the most common type of corporation in the United States. An S corporation (“S corp”) is a corporation that has elected a special tax status with the IRS. C corps and S corps share the following characteristics
- Limited liability protection
- Definition as separate legal entities
- Establishment via filing Articles of Incorpation
- Corporate structure made up of shareholders, directors, and officers
C corps are considered separate taxable entities by the IRS; they are required to file a corporate tax return and pay corporate taxes. Additionally, C corps are subject to “double taxation” – which is when corporate income (which has already been taxed) is distributed to business owners as dividends, and those dividends are considered personal income and are taxed accordingly, on the individual level.
S corps, on the other hand, are pass-through tax entities. Though they are required to file an informational federal return, and they do not pay out any corporate income tax. Rather, the S corp’s profits, or losses, are reported on the personal tax returns of the business owners and any tax that is due is paid at the individual level.
The Tax Cuts and Jobs Act of 2017 includes several major changes to the tax laws affecting corporations.
For C corps
- Income tax was lowered from a maximum rate of 35% to a flat 21%.
- Corporate alternative minimum tax was repealed, which will result in simplified tax reporting for many corporations.
- State income tax deduction was preserved.
- “Double taxation” was preserved – C corp dividends remain subject to the maximum 20% qualified dividend rate.
For S corps
- Income tax dropped from a maximum rate of 39.6% to 37%.
- Individual alternative minimum tax was preserved but now phases in at a higher level.
- Individual deductions for state and local taxes are now capped at a combined $10,000.
- Pass-through income that meets the requirements of qualified business income (QBI) is now eligible for a 20% deduction (this is currently set to expire for tax years beginning after 2025).
Though it may seem advantageous to restructure your organization, there are many elements to consider before making the switch. Be sure to consult your tax advisor to determine which option is best for your specific situation.