One of the vexing questions is, “Is it time to convert my C Corporation to an S Corporation?” This is most likely the year that it would be best to convert given the changes to the tax law that took effect yesterday.
Beginning with tax years beginning on or after 1/1/18, most C Corporations will be subjected to a flat tax of 21% of taxable income. If you are a professional type of business, one where the shareholders also work and capital isn’t a major contributor to profits, it appears you are still subject to the 35% tax rate. Although in truth, your taxable income is probably close to zero since all of the shareholders want a share of the income they generate. No matter how one cuts it, a percentage of zero is, well, zero.
This being said, it is possible that the new Tax Cuts and Jobs Act does change the rules for PSC’s. I doubt it though as it would make personal income potentially subject to a lower tax rate just because you kept the earnings in the business. The pass-through part of the new tax law denies the 20% deduction for personal service entities so it is unlikely that PSC’s as C Corporations get the lower rate as well.
Since all the income is passing to you currently as wages, nothing has to change for the conversion. You would keep the same basic overall compensation plan, with some minor tweaking most likely. You would likely keep the same benefit plan, although where and how it is deducted will change. The only real change is who reports the taxable income and then pays whatever tax is calculated.
On the Corporation side, you will need to have a business valuation performed. I would recommend getting one, even if you have a working buy-sell agreement. This is going to be the value that is treated as C Corporation gain assuming the Corporation sells its assets to a buyer. If you are unlikely to sell all the assets of the business (as a whole), then it won’t matter.
If you sold the assets and goodwill today as a C Corporation, by the way, the Company would be subject to a maximum 21% tax rate on the sale. The Corporation would then liquidate by paying all the cash out to the shareholders. Most well-structured firms will have very little in the way of intangible assets that are controlled by the Company so the gain will be the depreciation recapture from the sale of the tangible assets. In other words, minimal gain.
Given the tax law and the remoteness (but not impossibility) of the opportunity for Congress to rewrite taxes, this should be a fairly straightforward exercise. Definitely check with your tax professional – or feel free to contact us for help – to make sure you structure the transaction correctly but otherwise, give this serious consideration.
For those professional businesses structured as C Corporations for reasons other than “it was the way to do it way-back-then” I would still consider changing your tax structure. The cost might be a little higher but probably worth it in the end. So, if you have any of these issues:
- Foreign ownership (non-us citizen)
- Ownership by other entities like corporations or partnerships
- More than 100 shareholders
- Defined benefit plan (pension targets to the shareholders)
- Major capital investments which generate profit
Then an S Corporation will likely not work. So, instead of converting to an S Corporation, you may wish to consider:
- Setting up a Limited Liability Company structured as a Partnership
- Appraising your assets and/or value the business
- Selling your assets to the LLC
- Creating new compensation agreements with key employees
As an LLC(P), all of the income which flows to you will likely be treated as self-employment earnings. Which, by the way, was how you were originally taxing it as a C Corporation. The key difference is that you, not the LLC(P) will pay 100% of the tax. It is the same total tax though.
The C to S Conversion is set in the IRC so the steps are pretty straightforward. The concept of Corporation to Partnership conversion is not codified so therefore the risk is higher. Properly documented though, there are not a lot of pitfalls. It is always the lack of documentation and simple greed which gets deals like this in trouble.
So, if you are a C Corporation it may be time to seriously look at converting to a pass-through entity. For some professional firms, the fear has been increased risk but the case law for LLC(P) and S Corporation legal jeopardy has been pretty well litigated and the track record shows that, again with proper documentation and a sound business approach, most risk is mitigated. And with this hurdle addressed, perhaps it is time to seriously consider the benefits of restructuring.
Oh by the way, you only have until March 15 to file the paperwork to request permission to become an S Corporation. So there is not a lot of time to hem and haw. If you have been thinking about it, then this might be the right time to get it done.
Have a great day. As always, if you would like the name of a professional to assist you, please contact me through our website. As we focus almost exclusively on HOA and Condo audits, we do not prepare taxes ourselves but we can assist you in documenting and analyzing the conversion and how best to approach the steps. We look forward to the opportunity to be of service to you.