Conventional wisdom for most small business owners who incorporate is to elect to have corporate profits taxed directly to owner on their personal returns. This "S election" eliminates the double tax experienced by C corporations where profits are taxed first to them and a second time to owners (shareholders) when distributed as dividends. However, changes in tax rules made by the Tax Cuts and Jobs Act (TCJA) challenge this conventional wisdom, leading some S corporation owners to consider ending their S election. The questions that should be asked are:
1. Whether it's advisable to do this?
2. How to go about becoming a C corporation?
3. What the consequences are of ending S status?
Here, I'll address each one of these questions and walk you through the issues to consider.
Is terminating the S election advisable?
The TCJA established a flat 21 percent tax rate for C corporations. In contrast, owners of S corporations pay income tax on their share of profits, ranging from 10 percent to 37 percent. The effective rate of tax on owners can be cut somewhat by claiming the qualified business income (QBI) deduction. However, some owners may be able to claim only a partial 20 precent deduction, or none at all. For example, owners in specified service trades or businesses (SSTBs), such as consultants, attorneys, accountants, doctors, and performing artists, do not get any QBI deduction if their taxable income in 2018 is greater than $415,000 if they file a joint income tax return, or $207,500 on any other return (the taxable income amounts are adjusted for inflation after 2018).
There's a new limit on the extent of business losses that can be claimed by owners of pass-through entities, such as S corporation shareholders. There is no comparable limit on losses for C corporations.
And certain C corporations, such as those in manufacturing, technology, retail, or wholesale, can issue "qualified small business stock" (also called Section 1202 stock after the section in the Tax Code that governs it) to enable shareholders to have tax-free gains in the future. (This isn't new under the TCJA.) The stock must be held for more than five years and meet other requirements, but it's unique to C corporations.
How to end an S election
You can revoke an S election by taking a shareholder vote on the matter. A simple majority will do for Internal Revenue Service purposes, although a corporation's by-laws may require a greater percentage. Then you notify the IRS, specifying the date on which the revocation is effective. The IRS has some guidance on this. And make sure to attend to state-level matters if the S election is effective for state income tax purposes.
The S election can also be ended by becoming disqualified to be an S election. This occurs if you bring in an ineligible shareholder (e.g., a corporation, partnership, or nonresident alien individual) or you create a second class of stock. In this situation, the S election terminates on the date of becoming disqualified.
Consequences of ending the S status
You may need to change your accounting method and report some income resulting from the change. This occurs if the S corporation uses the cash method of accounting and the new C corporation cannot continue to do so (it must use the accrual method) because the company's average annual gross receipts for the three prior years exceed $25 million (adjusted for inflation). But an "eligible terminated S corporation" reports any income adjustment resulting from a change in accounting ratably over six years. An eligible terminated S corporation is any C corporation that:
- Was an S corporation on December 21, 2017;
- Revokes its S corporation election after December 21, 2017, but before December 22, 2019; and
- Has the same owners of stock in identical proportions on December 22, 2017, and the revocation date.
(Even if the corporation could continue to use the cash method but wants to change to the accrual method, the same six-year period applies.)
If the corporation had funds it's holding that were taxed before a revocation but were not distributed to shareholders, there's a limited window of opportunity to distribute them tax free. There's a post-termination transition period created by the TCJA, which runs from the date after the termination and ends either one year after the termination date or the due date for filing the final S corporation return (including extensions), whichever is later.
If shareholders prefer to become a C corporation and revoke or terminate the S election, keep in mind that a new S election generally cannot be made for five years. So if tax laws change to favor S status in the near future, owners likely won't be able to take advantage of them.
Whether or not to end the S election depends on each corporation's situation. Tax experts differ on whether it is generally advisable to do so. Some emphatically say yes, while others have suggested a wait-and-see approach to determine the impact of the new tax laws. The best course of action is to work with a certified public accountant or other tax adviser and consider the question now in light of the particular situation.