Should a C Corporation with the 21% Tax Rate Be Seriously Considered over an S Corporation or LLC?
Mario J. Fazio, Esq.
The Tax Cuts and Jobs Act of 2017 (“2017 Tax Act”) reduced the C Corporation federal income tax rate to 21%, effective January 1, 2018. Because of this tax rate reduction, business owners may want to consider whether there is a tax advantage of operating the business as a C corporation. Existing businesses may convert from a flow-through tax entity (i.e., a partnership, LLC or S corporation) to a C corporation typically at no or very little tax costs. This Tax Brief discusses several considerations that a business owner and its advisors may want to take into account in deciding whether a C corporation is preferable.
Flow-Through Entities Historically Preferred.
Most privately-held businesses are organized as flow-through entities, including LLCs, S corporations, sole proprietorships, and partnerships, because of the lower effective tax rate that historically applied to distributed earnings. Earnings from a flow-through business are taxed to the owners of the business at their individual tax rates. Prior to the 2017 Tax Act, the top federal income tax rate for an individual was 39.6%. After payment of both federal and state taxes, the owners could expect to be left with about 55% of the earnings (assuming a 5% state tax rate). If the business was organized as a C corporation, prior to the 2017 Tax Act, the effective federal tax rate was 34% on the C corporation’s earnings, and the top federal tax rate for an individual shareholder for dividends was 20%, plus an additional 3.8% for net investment income tax. The C corporation combined federal tax rate on distributed earnings was 49.7% [34% + (.66 x 23.8%)]. After the payment of both federal and state taxes, the shareholders of a C corporation could expect to be left with about 45% of the earnings.
As you can see, the C corporation structure resulted in a tax rate of an additional 10%. For this reason, LLCs, partnerships and S corporations generally have been favored over the C corporation.
2017 Tax Act Rate Changes.
Effective January 1, 2018, the federal income tax rate for C corporations was lowered to 21%. As a result of the reduction in the C corporation tax rate to 21%, the maximum effective federal income tax rate for income earned by a C corporation followed by a dividend of the after-tax earnings to the shareholders is approximately 40% [21% + (.79 x 23.8%)]. There is no expiration date on the reduced corporate tax rate.
Effective January 1, 2018 through December 31, 2025, the maximum federal income tax rate for individuals was lowered to 37%. In addition, the 2017 Tax Act provides for the new Qualified Business Income Deduction (QBID), which generally entitles the business owner to a deduction equal to 20% of the net business income. There are limitations on the allowance of the QBID (for example, certain specified service businesses are limited or excluded, and there may be limitations if certain wages or investment in asset thresholds are not met). Assuming the QBID applies, the maximum effective federal income tax rate on business flow-through income to the owner is approximately 30% [37% – (37% x 20%)].
As you can see, the 2017 Tax Act generally preserves the additional 10% tax rate that applies to C corporation distributed earnings compared to a flow-through entity where the QBID applies. Accordingly, there is still a strong advantage for selecting a flow-through entity, rather than a C corporation, if the business is eligible for the QBID and the expectation is that all or a substantial portion of earnings will be distributed to the owners on a recurring basis. However, where a substantial portion of the earnings are expected to be retained by the business for reinvestment or to pay down debt, there may be an advantage to the C corporation structure as discussed further below.
Will Earnings Be Retained in the Corporation?
If the owners plan to reinvest a substantial portion of the earnings in the business to grow the business, the C corporation tax structure may have an advantage over a flow-through entity structure since the earnings would be subject to only a 21% maximum tax rate, until a dividend of retained earnings is declared. Thus, 79% of the earnings would be available for reinvestment in the business.
In the case of a flow-through entity, retaining the earnings generally won’t reduce the overall tax rate since the earnings are taxed to the owners whether or not distributed. Thus, the flow-through tax rate, assuming the QBID applies, is approximately 30%, exclusive of state tax on retained earnings. If the QBID does not apply, the tax rate is approximately 37%.
Accordingly, more after-tax retained earnings can be accumulated in a C corporation for reinvestment in the business or to pay-down corporate level debt. Over a period of years this “tax savings” may be meaningful and represent a real cash flow advantage for a C corporation that has such a reinvestment growth plan or debt repayment strategy.
Accumulated Earnings Tax for C Corporations.
As discussed above, a C corporation that distributes earnings to its shareholders results in a maximum federal tax rate of approximately 40%. However, if the earnings are retained, the shareholder dividend tax is generally avoided until a dividend actually is paid. Without a dividend, the corporate income tax rate is 21%. However, the Internal Revenue Code restricts the ability of a C corporation to elect to defer dividends if the retained earnings have accumulated to an amount that is beyond the reasonable needs of the business. In this regard, such excess retained earnings may be subject to an additional “accumulated earnings” tax of approximately 20%.
If the C corporation cannot justify the amount of its retained earnings with specific, definitive and feasible plans for use of such retained earnings, the accumulated earnings tax may apply to such excess retained earnings. Accordingly, although the C corporation has a 21% tax rate, this tax rate only applies to the extent that the earnings are reinvested in the business or are otherwise necessary for the reasonable needs of the business as established by the corporation by specific, definitive and feasible plans for use of such retained earnings. Since the actual amount of earnings growth going forward is uncertain, it is difficult to know whether all future earnings, or at least a substantial portion of the future earnings, will be necessary for reinvestment in the business. Thus, one risk is that the company’s earnings will outpace the capital needed for reinvestment and/or to pay-down debt. Excess earnings may ultimately need to be distributed, which results in the combine federal rate of approximately 40% on such distributed earnings as discussed above. This risk would have to be weighed against the projected “tax savings” that would be achieved through the deferral of dividend taxes on the earnings that are reinvested in the business or used to pay-down company debt. Moreover, as discussed below, in the case of a sale that qualifies for Section 1202 treatment, the dividend tax on sale/liquidation may be completed avoided.
Tax Implications for Future Sale of the Company.
There are tax implications arising from the type of business entity when the business is sold in the future that should be considered when selecting a business entity. From a federal tax standpoint, a sale of C corporation stock is taxed at a maximum rate of 20%, plus the 3.8% net investment income tax rate. If the C corporation qualifies for Code Sec. 1202 treatment (as discussed below), the C corporation stock may be sold without any taxable gain, making the tax rate 0%. A sale of an S corporation, LLC or partnership assets or equity interests (i.e., stock, LLC interests or partnership interests) is taxed generally at a maximum rate of 20% without any net investment income tax (assuming no underlying assets are ordinary income assets and there is material participation by the owners).
However, there may be impediments to structuring a sale transaction as a stock sale, rather than an asset sale, because buyers typically prefer the acquisition of assets over stock. If a buyer must consider a stock purchase, the buyer might assign a discount to the value of the shares compared to the value of the underlying assets of the business. A purchaser might insist upon a discount rate because of (i) lack of a tax basis step-up in assets when stock is purchased; and (ii) the risk of undisclosed liabilities when stock is purchased. If the sale transaction is structured as an asset sale by a C corporation, the effective tax rate on the sale gain is approximately 40% as discussed above. However, Code Sec. 1202 may result in a reduced overall tax rate for an asset sale by a C corporation through the elimination of the dividend tax when the sale proceeds are received by the shareholders in complete liquidation of the Company. Section 1202 only allows for gain exclusion on the sale or exchange of QSB stock, so C corporation asset sales are typically not eligible for Code Sec. 1202 gain exclusion. But, if a C Corporation’s assets are sold in complete liquidation, and those proceeds are distributed to the shareholders in accordance with a plan of liquidation, then the transaction is treated as being made in exchange for stock under Code Sec. 331. Thus, while a C corp asset sale would not normally qualify for Code Sec. 1202 gain exclusion treatment, if the assets of the Company are sold in the complete liquidation, then Code Sec. 1202 would apply and thus reduce the maximum tax rate on the sale from 40% to 21%. This rate is approximately equal to the flow-through tax rate on sale of 20%, as mentioned above.
Accordingly, if Code Sec. 1202 applies, a future change of control transaction could be structured as an asset sale by the C corporation to avoid any valuation discount that a buyer might apply to a stock sale structure and also achieve approximately the same tax rate (e.g., 21%) as would be the case if the business was a flow-through entity. Assuming the business qualifies for Code Sec. 1202 treatment, converting to a C corporation may not create a disadvantage with regard to the tax treatment on sale.
Qualification for Code Sec. 1202 Treatment.
Code Sec. 1202 provides for 100% gain for a shareholder exclusion on the sale or liquidation of qualified small business (“QSB”) stock that is held by the shareholder for five (5) years or more. Exclusion results in a 0% tax rate on gain realized from the disposition of QSB stock. QSB stock must meet the following requirements: (1) the stock is issued after 2010 by a C corporation (although partial gain exclusion is available for stock issued after 1993); (2) the C corporation issues the shares to the shareholder; (3) at least 80% of the corporation’s assets are used in the active conduct of a business during substantially all of the shareholder’s holding period of the stock; and (4) at any time prior to, and immediately after, the issuance of the stock to the shareholder, the gross assets of the corporation do not exceed $50 million. The maximum amount of gain exclusion is the lesser of $10 million or 10 times the adjusted basis of the shareholder in the QSB stock.
Certain businesses cannot qualify as QSB stock including the following:
(A) Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees;
(B) Any banking, insurance, financing, leasing, investing, or similar business;
(C) Any farming business (including the business of raising or harvesting trees);
(D) Any business involving the production or extraction of products of a character with respect to which a depletion deduction is allowable under §613 or §613A; and
(E) Any business of operating a hotel, motel, restaurant, or similar business.
Existing flow-through entities may convert to a C corporation with the ownership interests converted to QSB stock assuming the foregoing requirements are met.
For most existing businesses that are structured as flow-through entities and that qualify for the 20% deduction for QBI, converting to a C corporation may not be advisable because of the overall 10% rate advantage on distributed earnings for a flow-through entity under current law. A similar conclusion may be drawn for new businesses. However, a business that intends to reinvest substantially all of its earnings for a number of years going forward may want to consider the C corporation as an alternative. An additional critical factor is whether the C corporation stock can qualify as QSB stock, since QSB stock may result in substantially the same tax rate on sale for a C corporation compared to a flow-through entity.
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