To C or Not to C, That is the Question: When it Benefits Pass-Through Entities to Switch

March 20, 2018

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Business owners whose companies are structured as pass-through entities (where income passes through to the Form 1040 and is taxed at personal income tax rates) sometimes think they may do better if they switch their business to a C Corporation. In a C Corporation, income is taxed at the business level, and is a flat 21% tax rate. The process to determine whether or not to switch is one of the hotly debated topics among CPAs and clients this tax season. Answers to this question include yes, no, maybe, and my favorite: it depends. In the end, the answer is universally subjective, not only to each type of business, but to each individual.

The most common reason for small businesses not being organized as a C-Corporation is double taxation. Double taxation occurs when the C-Corporation pays tax on its net income, and the shareholders of the company pay tax on their returns for any dividends or salary received. Most new small business owners are organized as either Sole Proprietorships, Single Member LLCs, Partnerships, or S-Corporations. There is no tax at the business level, and all of the income flows to the individual owners Form 1040 and taxed at personal income tax rates.

Beginning in 2018, the new tax bill will make the tax on all C-Corporations a flat 21%. In addition, the new tax bill created a 20% deduction for pass through entities. This deduction has phase-outs and excludes certain businesses.

The question becomes: Is it worth it to switch my business to a C-Corporation? What if I am a small business owner that has income above the phase outs and/or is engaged in a business that might be excluded from the 20% deduction altogether? In order to complete the calculation, you need to determine how you will be taxed currently, and then how you would be taxed on that same income if you switched to a C Corporation. This calculation can be in-depth, as shown below, but it’s important to remember to make sure the comparison is equal.

In the example, we have a business owner who is Married Filing Jointly, taking the standard deduction, and phased out for the 20% pass through deduction. Under the owner’s current tax structure, the approximate tax is $117,979. Switching to a C-Corp and taking a $100,000 salary would result in a combined tax liability of $92,738.88. But that doesn’t tell the whole story. In the pass-through entity, the business owner is taxed on the entire $500,000 income; in the C-Corporation, the owner isn’t. The owner would still need to remove (either through wages or a dividend) the remaining $400,000 of money in the C-Corporation. Assuming the owner paid himself a distribution, and adding approximately 15% dividend tax to the example, would increase the C-Corporation tax by $60,000 for a total of $152,739.

Example:

Taxpayer Filing Status

Married, Filing Jointly

Married Filing Jointly

Pass Through Net Business income

$500,000

$0

Corporate Salary

N/A

$100,000

Corporate Business Income

$0

$400,000

($500,000-$100,000)

Corporate Business Tax

$0

$84,000

($400,000 x .21)

Can take 20% pass through Deduction

No

N/A

Standard Deduction

$24,000

$24,000

Taxable Income on 1040

$476,000

($500,000-24,000)*

$76,000

($100,000-24,000)*

Approximate Personal Federal Tax Due

$117,979†

$8,739†

Total Corporate and Personal Tax Due

$117,979

$92,738.88

($84,000 + 8,739)

Dividend Tax

N/A

$60,000

($476,000 x .15)

Total Tax including dividends

$117,979

$152,739‡

($8,739 + $84,000 + $60,000)


So when does it become beneficial to switch to a C-Corporation? Well obviously when the tax is lower. But there isn’t a way to know that unless you have your trusted advisor run the numbers. In some instances, you may need to run several scenarios. On a calculation I ran for a business owner that netted $6M a year in income, the tax savings to both owners in total was $200,000 year. As we ran multiple scenarios we found that for every $1M increase in sales, the owners saved an additional $25,000 in taxes each year. If you’re questioning switching to a C-Corporation, talk with your trusted advisor to help make the decision that’s right for you.

____________________

Notes:

* In 2018 the standard deduction is $24,000 for taxpayers filing married. There are no exemptions beginning in 2018.

† See 2018 tax brackets here

‡ Using the dividend tax rate may yield a slightly different calculation

Mark Puzdrak

CPA

Mark Puzdrak is a Certified Public Accountant (CPA) with more than 13 years of professional experience helping small to medium-sized businesses with their tax and accounting needs including individual, corporate, and partnership income tax returns along with business and individual tax planning. Mark is a member of the American Institute of Certified Public Accountants and the Texas Society of Certified Public Accountants. He is licensed as a Certified Public Accountant in Texas and Pennsylvania. He earned both of his bachelor of arts degrees in accounting and finance from Lycoming College in Williamsport, PA. Mark is committed to delivering tax and planning services that meet each client's unique objectives with a focus on services for small to medium-sized businesses as well as clients in the Real Estate, Manufacturing, Entertainment, and Professional Services industries. Mark lives in Austin, Texas with his wife, Kelly. He enjoys reading biographies, visiting small Texas towns, and the occasional scotch and cigar.
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