Last time, we looked at individual tax rates. This time, let’s look at the bigger picture of C Corporations.
C Corporations currently pay taxes on a graduated scale up to 35% of taxable income. Personal service corporations (attorneys, engineers, etc.) pay at a flat 35%. Beginning in 2018, all C Corporations will pay taxes at a flat 21% rate.
Many business owners and startups are asking if now is the time to convert to or start a C Corp. While the 21% rate is tempting, there are additional important factors to consider:
- Once income is taxed and included in C Corp equity, getting funds out comes at an added cost. The most common method would be a dividend, which is not deductible to the corporation. The recipient/shareholder is taxed at a federal rate of up to 20% (plus, there’s an Alabama tax of 5%). The Affordable Care Act’s 3.8% net investment income surtax still applies for married taxpayers with adjusted gross income over $250,000 ($200,000 single), increasing the total federal rate to 23.8%.
- If a business accumulates earnings beyond a “reasonable” amount to meet the needs of the business, it could become subject to the accumulated earnings tax at a rate of 20%. “Reasonable” is, of course, a relative term, so a business expansion or repurchase of stock would need to be carefully documented.
- Future plans to sell an entire business or assets are also a consideration. Most buyers want to purchase business assets rather than stock. If you are a C Corp, the corporation will pay federal and state tax on the net taxable gain from the asset sale. Then, if the corporation distributes proceeds to shareholders a second level of tax will be incurred most likely as a dividend.
- Usually new businesses incur losses for some period of time. With a C Corp, those losses are trapped inside the corporation and beginning in 2018 are only available to carry forward to future years. However, generally an LLC or S Corp could pass those losses out to the shareholders.
On the plus side: C Corporations have some advantages. Take the example of an undercapitalized professional services firm formerly taxed at a flat 35%. They can now leave income in the corporation and pay taxes at 21%. Corporation dividends taxed at capital gains rates actually could be taxed at 0% for some lower-income taxpayers. For owners, the C Corporation is probably the best entity to deduct fringe benefits.
Before making changes to current entities, our advice would be to view 2018 as a transition year and wait for additional guidance.
Please let us know if you have questions about the new tax laws and what they mean for you and your business. We are here to help.