The sweeping changes made by the Tax Cuts and Jobs Act have prompted many businesses to reevaluate their entity choice. Should they remain an S corporation or become a C corporation? Should a limited liability company make a change in entity choice? Should a sole proprietorship incorporate? There are no easy answers.
Revoking an S election
To take advantage of the flat 21 percent corporate tax rate, some S corporations have or are considering a revocation of their S election. There is no consensus among tax professionals whether to make the change. Much depends on the type of industry the S corporation is in and other factors. Here are some examples:
- Access to Section 1202 stock. C corporations in certain industries can issue stock that when held more than five years entitles the seller to tax-free gain.
- Access to equity crowdfunding. Raising capital is easiest for C corporations as compared with any other entity choice. In particular, small businesses can raise funds through equity crowdfunding platforms; they issue stock in exchange for the funds that are raised.
LLC electing to be taxed as a C corporation
An unincorporated business can choose to be taxed as a C corporation. This is easily done by merely "checking the box." This means filing IRS Form 8832, Entity Classification Election to elect to be an association taxable as a regular corporation. The upside is having profits taxed at the flat 21 percent rate for C corporations. This may be especially appealing to a business where owners may be barred from using the 20 percent qualified business income deduction.
But the main downside to being taxed as a C corporation is double taxation. When earnings that have already been subjected to corporate tax are distributed to owners, they are not deductible by the business while the owners pay tax on what they receive. Of course, double taxation can be avoided by paying out funds as compensation (deductible by the business to the extent it is "reasonable") or loans (as long as they are bona fide).
Incorporating a sole proprietorship
Perhaps the most dramatic change in entity choice is going from being a sole proprietorship into a C corporation. Incorporating the business gives the owner personal liability protection and a new tax picture. The owner becomes an employee of the corporation, so that self-employment tax that the sole proprietor previously contended with gives way to FICA and other employment taxes. And profits are taxed to the corporation, not directly to the owner. The owner pays tax on compensation and dividends distributed by the corporation.
The question is whether incorporating will ultimately save taxes for the business owner. Incorporating means no access to the new qualified business income deduction. And the potential for double taxation on earnings is ever present.
State tax considerations
Businesses must factor in state tax implications in any decision to make an entity change. For example, while the federal corporate tax rate has been reduced dramatically, most states' corporate tax rates have not changed.
The choice of entity and whether to make a change from your current form is a complex matter, involving not only federal and state taxes, but also non-tax considerations (e.g., personal liability protection, access to equity crowdfunding). Each situation is unique, and it's often advisable to get assistance from a certified public accountant or other tax pro.