How Changes in Corporate Tax Rate Can Affect Choice of C vs. S Corp.

Editor: Alan Wong, CPA

Corporations & Shareholders

In February 2012, President Barack Obama introduced The President’s Framework for Business Tax Reform, which proposes many changes in the tax law, including a reduction in the top corporate tax rate from 35% to 28%. This item examines the effect of the proposed lower corporate tax rates in an analysis of the tax results of converting an S corporation to a C corporation. According to IRS statistics, 1.78 million C corporation returns and more than 4 million S corporation returns were filed for tax year 2008. It is presumed that lowering C corporation tax rates by seven percentage points (from 35% to 28%) would prompt many small businesses to consider changing their tax status.

As the law stands, a large number of businesses in the United States have chosen to organize in the form of flowthrough entities such as S corporations, partnerships (either general or limited), and limited liability companies. In general, flowthrough structures result in profits being taxed at lower individual rates and, potentially, lower taxes due upon sale of the business. As a result, taxpayers generally pay lower taxes and avoid the trap of double taxation.

Many small business owners have viewed C corporations as an entity of last choice because they have some noticeable disadvantages. At the top of the list is the potential for double taxation because profits are taxed at the entity level and at the individual level when distributions are made in the form of dividends. Also, unlike their flowthrough counterparts, C corporations do not separately state income or loss items. These are combined to arrive at total taxable income, with the same tax rates applying to ordinary income and capital gains. Since income does not retain its original character in a corporation, many of the benefits available at the individual level are lost when the corporate form is chosen.

Example: A, a single individual, owns 100% of an S corporation’s issued stock. For many years this company has been profitable, and the business has discretionary cash flow available for distribution to the owner. A has been paying taxes at individual tax rates. As his individual marginal tax rate becomes higher than the corporate tax rate, this owner may be motivated to convert to C status.

Assume that in the first year of operation after restructuring to a C corporation, total taxable income is $2 million, and there are no distributions. Also assume that Congress has enacted a top marginal rate of 28% for corporations and that all income is taxed at the top marginal rate. Exhibit 1 shows the tax savings as a C corporation. The corporation’s taxes are $140,000 less than if all the income had been distributed to the owner ($700,000 – $560,000).

Now assume that the taxpayer receives a qualified dividend from the corporation for $250,000 in the first year of operation as a C corporation. Assume in this situation that the taxpayer pays additional taxes on the dividends at the individual level at a rate of 15%. Exhibit 2 summarizes the effects from double taxation. Although the second layer of taxes hits the taxpayer with an additional $37,500 in federal taxes, the taxpayer still has net tax savings of $102,500 ($700,000 – $597,500) when compared with the tax liability at the individual level.

In this example, the corporation’s ability to fund dividends may be limited. Factors that must be considered in the selection of corporate tax status are profitability, cash flow, debt-service requirements, capital-spending needs and policies, growth of business plans, and likelihood of selling the business. The financing of corporate growth would be enhanced by lower corporate income taxes. For small businesses whose owners are not in the highest tax bracket, an analysis yields a narrower result.

In addition, the qualified dividend rate of 15% is currently scheduled to expire at the end of 2012. After its expiration, dividends will be taxed at ordinary income rates. For most small business owners, this will mean a much higher rate of tax on dividends, which would make double taxation’s impact felt at a lower dividend level. In Exhibit 2, with a 15% tax rate on dividends, taxes paid under the C corporation structure would exceed taxes paid under the S corporation structure only when dividends exceeded $933,333. If the owner’s dividends were taxed at the 35% income tax rate, on the other hand, dividends exceeding $400,000 would push the taxes paid under the C corporation structure above the $700,000 paid in the S corporation structure.

By now, it is clear that changes in the corporate rate would create some winners and losers. Tax practitioners should monitor closely the status of these laws to analyze any positive or negative impacts on their clients. There is no general rule for addressing all possible tax effects when restructuring to a C corporation, but given a large spread in tax rates, some businesses could gain an advantageous position.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.

For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.