The Tax Cuts and Jobs Act (TCJA) of 2017 made two significant changes to the U.S. Tax Code that have encouraged some businesses to consider abandoning their status as an S corporation and seek to be taxed as a C corporation. That is because the legislation implemented a 21% flat tax on all C corporations and capped an individual’s federal deduction for state and local tax (SALT) at $10,000 annually. However, while the TCJA may make electing C corporation status more attractive to some businesses, there are no one-size-fits-all solutions for choosing one over the other.
One of the primary reasons that companies form as S corporations rather than C corporations is to avoid what is often referred to as the “double taxation” of C corporations by the federal government. Double taxation occurs because a C corporation’s income is taxed both when it is earned by the C corporation and again when it is distributed to individual shareholders as dividend income. S corporations are treated as passthrough entities for federal tax purposes because all corporate income is passed directly through to the shareholders where it is taxed as income.
TCJA Lowered the Tax Rate for Large C Corporations
While the TCJA did not do away with the double taxation of C corporations, it did lower the tax rate for larger C corporations substantially by imposing a 21% flat rate across the board. Before the act was enacted, C corporations were taxed at $25% on income of $50,001 and $75,000, 34% on income of $75,001 and $10 million, and $35% on income of more than $10 million. But for smaller C corporations with incomes of $50,000 or less, the TCJA actually raised the tax rate from 15% to 21%.
The tax owners of an S corporation who are married, filing jointly and claim the standard deduction will not be subject to an effective tax rate of 21% on their passthrough income from the corporation until their adjusted gross income (AGI) reaches more than $400,000 for 2020. A taxpayer’s effective tax rate is calculated using the average tax rate paid on all of a taxpayer’s earned income. Even if the calculations are based on the marginal tax rate, rather than the effective tax rate, married taxpayers filing jointly are in the 22% income tax bracket until their taxable income exceeds $171,050 for 2020.
Some Small C Corporation Stock Sales Tax-Free
In some situations, a shareholder in a small business C corporation will plan on eventually cashing out and selling his or her stock. Those shareholders may be eligible to take advantage of the federal qualified small business (QSB) stock exclusion, which allows up to 100% of the gain from the sale of QSB stock to be excluded from the federal capital gains tax. Qualifying small businesses must be an active domestic C corporation with gross assets that did not exceed $50 million when the stock was issued or afterward. Businesses operating in certain fields are also not eligible as QSBs, including those in the financial sector, hospitality industry, personal services, mining, and farming.
To take advantage of the exclusion, the investor must have purchased the stock with cash, property, or in return for services when the C corporation initially issued the stock. The investor cannot be a corporation itself and must have held the stock for at least five years before selling. Finally, at least 80% of the corporation’s assets must be used in qualifying activities, including retail, wholesale, manufacturing, and technology.
The amount of gain that a stockholder may exclude depends on how long the stock has been held. QSB stock acquired after September 27, 2010, receives a 100% exclusion on the capital gains from its sale. Shareholders selling QSB stock acquired between February 18, 2009, and September 27, 2010, may exclude 75% of the capital gain. For QSB acquired between August 11, 1993, and February 17, 2009, a 50% capital gains exclusion applies.
The exclusion is capped at either $10 million or 10 times the stock’s adjusted basis, whichever is larger. Therefore, if the adjusted basis was $2 million, the taxpayer may exclude up to $20 million in gain from QSB stock sale.
SALT Cap Limits Deductions for S Corporation Shareholders
By itself, the reduced rate was not likely to drive small and mid-sized S corporations to change to C corporation status. But the SALT cap left many S corporation shareholders living in high-tax states like California paying tax on more of their income because the SALT cap limited the deductions they could claim on their individual returns. As a result, their S corporation income could be taxed at a rate of up to 37%, which is significantly higher than the maximum 20% rate on qualified C corporation dividends.
The tax bite of the SALT cap has been limited by a provision in the Tax Code that give the owners of passthrough entities like S corporations a 20% deduction for qualified business income (QBI). QBI is the income, gain, deduction, or loss resulting from the taxpayer’s ownership of an interest in an S corporation. QBI does not include items that cannot be included in taxable income, wage income, investment income or loss, dividends, and similar items.
While beneficial to most S corporation shareholders, the QBI provides less tax relief for shareholders earning high incomes. The deduction begins phasing out at $323,600 for married taxpayers filing jointly in 2020 and is phased out entirely at $426,600. For single taxpayers, it begins phasing out at $163,300 and phases out completely at $213,300.
Lastly, S corporation status is generally better for businesses that are experiencing financial losses. When a C corporation experiences losses, the losses stay within the business and are not passed on to the shareholders. Shareholders in an S corporation can use its losses to offset other income on their federal returns.
Reinvestment in C Corporations Encouraged
One situation where structuring as a C corporation will lead to more tax savings than an S corporation is when businesses do not make distributions to shareholders. This happens when the corporation pays the owners a salary, but all the corporate profits are reinvested in the company. Since the profits are not distributed to the shareholders, they are not taxable dividends and are only taxed at the 21% corporate rate. This avoids double taxation for the shareholder. However, eventually the C corporation will likely want to distribute its earnings to its shareholders, and those distributions will be taxed at the shareholder level.
If the C corporation is closely held and at least 60% of its income is passive and not distributed to shareholders, they may be subject to the personal holding company tax. Likewise, C corporations are subject to the accumulated earnings tax if they accumulate more earnings that the company reasonably needs.