With the recent changes in the Tax Cuts and Jobs Act and C Corporations seeing significant benefits, many have begun to circle back on their entity status.
Why were tax rates reduced for C corporations under the new law?
To put it simply, they wanted to incentivize the ‘big boys’ who chose to operate overseas to bring their operations back to the United States. Reduced rates will decrease the tax revenue base, but are expected to stimulate economic growth and provide jobs within our borders. In addition, bringing untaxed profits back to the U.S. is expected to significantly increase the income taxes collected in coming years and reduce the pressures to raise the income tax rates in the near term.
How much was the actual rate reduction?
The top published Federal corporate income tax rate for 2017 was 35%, but effective for tax years beginning after December 31, 2017, it’s a flat rate of 21%. This rate reduction is expected to reduce the overall tax burden and significantly enhance the bottom line for entities moving forward.
Should you revoke your Subchapter S election and be taxed as a C corporation moving forward?
This may not be an easy decision and will depend on facts and circumstances. Shareholders can voluntarily revoke the Sub S election at any time. Prior to the recent changes in the tax law, the two most common reasons were:
- The company’s intent to go public or increase its’ investor base to over 75 investors, C corporations may have an unlimited number of shareholders. They can also offer multiple classes of stock to their investors.
- The company’s desire to increase deductible fringe benefits to its shareholders.
How would you revoke your Sub S election?
In order to make it effective as of the first day of your taxable year, it must be filed before the 15th day of the third month of that year. For example, to be effective January 1, 2019, it must be revoked by March 15, 2019. Keep in mind, though, if the election is revoked, there is typically a five year waiting period to re-elect.
In order to revoke your S election you must take the following steps:
- File a “Revocation of S Corporation Status” with the IRS Service Center where the original S election was filed.
- Have the revocation signed by a person authorized to sign the corporate income tax return
- Attach a statement of consent signed by shareholders owning more than 50 percent of the outstanding stock
C corporations may be best for very profitable corporations who retain their earnings, and don’t distribute dividends to their shareholders. There is no immediate gain realized by converting an S corporation to a C corporation, and corporations are given a limited period of time to distribute tax-free their old S corporation earnings. However, a new C corporation, will need to be aware of the Accumulated Earnings Tax.
Accumulated Earnings Tax
Corporations are allowed to accumulate earnings for possible expansions or other valid business purposes. If the corporation allows its earnings to accumulate beyond the reasonable needs of its business, it could be subject to an additional tax of 20% on those excess earnings.
What are considered ‘reasonable’ needs of the business?
Here are just a few:
- Operating
- Plans for using the earnings for debt curtailment
- Plans to acquire fixed assets
- Plans to expand its workforce
- Redemption of outstanding corporate stock
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Pass–through entities are still good vehicles for tax minimization. Owners can avoid the effects of ‘double-taxation’ during operation and at the time of liquidation. Some passive S corporation owners may be able to receive distributions that aren’t subjected to payroll taxes. Some shareholders even end up in lower tax brackets than the flat corporate income tax rate.
I’m not currently planning on a rush to revoke any Sub S elections, but as this year unfolds, we need to keep our minds, and eyes, open. It is something to consider in your income tax planning during the 2018 tax year to be effective in 2019.
Meet the Author
There is a lot of literature available to assist you with this decision, but the experience and guidance of your professional advisors is most helpful in avoiding unforeseen outcomes. If you would like to discuss your current or future business structure, please contact YHB (Yount, Hyde & Barbour, P.C.) Principal Tom Moler by email at tom.moler@yhbcpa.com or by phone at 703-777-7739.
