C Corporations vs. S Corporations under TCJA

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When a corporation is formed, it is by default a C corporation (C-corp) for tax purposes. It may then elect to be taxed as an S corporation (S-corp) instead. Whether or not it does so will impact the taxation of its income as well as other considerations. Passage of the Tax Cuts and Jobs Act (TCJA) in December 2017 added further complexity to this decision.

 

An S-corp does not pay federal tax at the corporation level. Instead, its income is passed through proportionately to its shareholders, who pay tax on it on their personal returns. The top federal tax rate for an individual under TCJA is 37%. Many S-corp owners can take advantage of the 20% pass-through deduction enacted under TCJA (see LMC TCJA Alert #4 and later updates), which effectively reduces the federal tax on the income to a maximum of 29.6% (owners in lower tax brackets will pay less).

 

The states also allow S-corp income to pass through to the shareholders' personal returns. Some (like New York State and New Jersey) require a separate state S-corp election form; others (such as California) follow the federal election. New York City does not recognize S-corp status and taxes S-corps like C-corps, at the business level.

 

By contrast, the federal tax rate for C-corp profits was reduced under TCJA to a flat 21%. On its face, this is lower than the personal tax paid on S-corp income. But income earned by a C-corp is retained in the corporation and cannot be used personally by the shareholders until it is distributed to them as a dividend. In most cases an additional 18.8% federal tax is paid on this dividend at the individual level. Thus the overall tax paid on C-corp income which is then distributed to its owners is 35.852%, significantly more than the tax on S-corp income eligible for the pass-through deduction.

 

If a corporation intends to retain most of the cash it earns (for example, to expand the business or invest in other assets), the low C-corp rate would leave the most after-tax cash available in the corporation. But if it plans to pass the funds it earns to its owners to use personally, an S-corp structure may save the most tax. Which arrangement provides the greater tax benefit must be analyzed on a case-by-case basis.

 

Some S-corp owners will not be eligible for the 20% pass-through deduction. Factors include the type of business, the amount of income the owner reports, the amount of wages deducted, and the amount of fixed assets the business owns. Whether or not a pass-through deduction is allowed becomes part of the C-corp/S-corp analysis.

 

Issues unrelated to TCJA also factor into the decision. An S-corp is limited to 100 or fewer owners, may only have one class of stock, and may not have any foreign shareholders. A C-corp has more ability to raise money from investors since an S-corp may not have as an owner any corporation, LLC, or partnership. C-corp owners (but not S-corp owners) may be eligible to exclude all gain on the sale of stock held for five years. C-corps have greater flexibility to deduct fringe benefits, but S-corp owners can write off losses (common in the first few years) against other income on their personal returns.

 

Your LM Cohen professional can help you determine if C-corp or S-corp status (or perhaps a non-corporate structure such as an LLC) is best for your business. All our prior Tax Cuts and Jobs Act Alerts are available on the Updates page of our website.

 

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