Are you using the most advantageous business entity? There are many things to consider when choosing a business entity type but choosing the right one for your situation can save you a lot in tax and may be able to limit your personal liability.
Thinking about converting from a C-Corporation to an S-Corporation or vice versa?
The primary reason for changing from a C-Corporation to an S-Corporation is to avoid double taxation without the need to liquidate the corporation. A C-Corporation’s income is taxed at the corporate level when the income is earned and then again when shareholders receive distributions which are considered dividend income. S-Corporation’s earnings are taxed once at the individual shareholder level. Recent tax reform decreased the corporate tax rate from 35% to 21%. Every business owner should consider if they are using the most appropriate entity type.
The following examples are a simplified illustration of the tax consequences under each entity type and assume income tax is paid at the highest marginal tax rate.
Example 1: A C-corporation earns $1,000 in income before taxes in year 1, it pays $210 ($1,000 x 21%) in federal income taxes in year 1. When the corporation distributes the remaining $790 ($1,000 income -$210 taxes) the shareholder(s) who receive the distribution would pay $188 of income tax ($790 x 23.8%). The resulting total income tax paid on the $1,000 of income is $398.
Example 2: If the corporation had elected S status and earned the same $1,000 as in example 1 the S-corporation would pay $0 in Federal entity level tax. The $1,000 would be reported on the shareholder(s)’ return. This income might be eligible for the 20% pass-through income deduction enacted as part of the recent tax reform bill. If the income is eligible, the tax would be calculated on $800 [$1,000 income – $200 ($1,000 x 20%)]. The resulting federal income tax liability on the $1,000 of income would be $296 (800 x 37%).
Read more about the pass-through income tax deduction in our article “Tax Reform: Pass-Through Income Deduction Edition”
Other important tax consequences exist, such as Built-In Gains Tax. S-Corporations that were previously C-Corporations may also pay taxes on accumulated, untaxed income that resulted from when the corporation operated as a C-Corporation. The company needs to measure the fair market value at the effective date of the S-election as compared to the tax basis to measure the amount of unrecognized appreciation. The amount of unrecognized gain is determined for each asset separately then the net of unrecognized built-in gains and built-in losses is the corporation’s total unrecognized built-in gain. It must track the disposition of these assets for the next 10 years, at which time any built-in gains are taxed at a rate of 21%.
It should also be noted that, if the C-Corporation has net operating losses that are not used, those losses cannot be used to offset its income generated as an S-Corporation and in turn cannot be passed through to its shareholders. If the unused losses cannot be carried back to a previous tax year then those losses will be forfeited upon the conversion.
Should your business be an LLC?
If you are operating a sole proprietorship, you may want to consider converting it to an LLC. The benefit of operating as an LLC is that it offers limited liability protection. In the case of a sole proprietorship there would be no federal tax impact of forming an LLC.
LLCs that operate in California are required to file a separate LLC return and are subject to an annual tax of $800 plus an LLC fee. The LLC fees is calculated on the total California sourced gross receipts.
Owners of LLCs are referred to as members. If you decided to add a member to your LLC, both members would have limited liability protection. One of the benefits of using an LLC vs. a C-Corporation is that you are not subject to double taxation.
It is easy to convert from an LLC to a C-Corporation if you later decide the business needs to be incorporated. This could be the case if you are planning on getting venture capital funding, as many venture capital firms require a corporate form. Another benefit on using a C-corporation is the ability to qualify for the 100% gain exclusion on Qualified Small Business Stock (“QSBS”). There are several criteria that must be met including holding the stock for 5 years in order to qualify for this tax savings.
If you have any questions about this topic, or any other tax matters, please feel free to contact your L&B professional at 858-558-9200.