This is why working with a financial planner that has a tax background is critical. Lionshare Partners LLC was registered to do business on December 12th, 2017 and less than two months later one of my blogs is already obsolete. I recently wrote about the decisions behind choosing a S Corp or C Corp as the entity for your operation. Well with the new tax law dropping the top corporate rate to 21% and shuffling the deck on tax strategies it is critical you meet with your tax advisor soon to discuss the best situation for your ongoing enterprise. After all, as your business grows and evolves, what is the likelihood that the same choice of entity that worked for you five years ago still works today?
And what’s funny is for the last 31 years, the choice of entity for the majority of entrepreneurs has been a binary one: they will be an S corporation, or they will be a partnership (LLC). Why? Think about the pre-2018 corporate landscape: corporate-level income was taxed at 35% (compared to top tax rate of 39.6% for individuals). A subsequent distribution of cash was taxed to the shareholder at a top rate of 23.8%. And a distribution of appreciated assets by a corporation to a shareholder was treated as if the corporation sold those assets for fair market value.
So, the question you need to ask when meeting with your tax advisor is “Should my business be a C Corp?” There are several reasons to consider the move besides the lower tax rate on profits. For example, the cash method of accounting is now available until average gross receipts exceed $25 million. Tack on the benefits of the new 100% asset expensing rules, a top corporate rate of 21% on personal service businesses, the doubling of the estate tax exemption, and the pre-existing benefits afforded only to C corporations that tax reform did nothing to dilute: For example, the ability to provide tax-free fringe benefits to shareholder/employees, and an exclusion from gain on the sale of stock held longer than five years under the recently-expanded Section 1202. Add all these things up, and C corporations can no longer be an afterthought.
Yes, ask your tax advisor about the Section 1202. This is one of those crazy capital gains exclusions exploited by Private Equity firms and often missed out by ordinary small business owners. But the Section 1202 allows the potential to sell your C corporation stock after five years without paying tax. Yeah, you heard me!
Make sure you run some long-term (10 year) projections with an exit (liquidation event) to truly see which entity works best for you. Because a C corporation might “lose the battle” each year relative to flow-through entities by paying slightly more in tax, the owner of that C corporation can sell their stock (Section 1202) and exclude the gain under Section 1202 (not available to S corporations or partnerships). That large tax savings at the exit could be ultimately matters in terms of overall tax savings.
Generally speaking, the two levels of tax would still make a corporate operation less advantageous than a flow-through entity. However, if you do not pay out dividends–and are rather planning to re-invest a majority of profits back into the business as part of a long-term strategy (like a manufacturer) –then the C corporation is a solid option. If you have multiple business lines under one entity, it could make sense to break them into separate businesses to take advantage of the reduced corporate rate and other aspects of the new law. Consequently, corporations with shareholders taking significant bonuses at year-end will not necessarily benefit by a move to a C corp because some of those bonuses will have to be treated as dividends.
Other items to consider before changing your business taxing structure include:
- Owners’ ability to deduct losses at personal level with pass-through treatment versus having the losses trapped inside the C-Corporation structure.
- Lack of step-up on sale for buyer.
- Accumulating appreciable assets C-Corporation, double taxation structure.
Be mindful if you are on the “I got screwed list” under the new tax code that do not qualify for the pass-through deduction. This list is corporation that are professional services — which could encompass legal counsel, financial consulting, athletes, doctors, or freelance design work. If this applies, you should consider taking the time to re-organize, and there are workarounds to avoiding being double taxed.
Lastly, for those who wish to move quickly, the process of converting to a C corporation could theoretically take less than a week. California is one of the states that allows for “statutory,” or streamlined, conversions. Briefly, to convert a California LLC to a California corporation, you need to: adopt a plan of conversion; and file Articles of Incorporation containing a statement of conversion with the Secretary of State.