Expiration of the Bush-era tax cuts raised the top individual income tax rate to 39.6 percent, prompting owners of pass-through entities to consider switching to C corporation status to avoid higher individual taxes.
“Now that the tax rate for pass-through entities like S corporations and partnerships is effectively going up because individual tax rates are going from 35 to 39.6 percent, people are wondering if it still makes sense to be a pass-through entity,” says Alan Villanueva, a tax partner at Moss Adams. “In California, a proposition passed in November increased the maximum state individual rate from 10.3 to 13.3 percent, so a California resident with a pass-through entity is looking at a combined rate of almost 53 percent.”
Smart Business spoke with Villanueva about the advantages and shortcomings of the different corporate formats and whether businesses should switch.
What are the tax differences between pass-through entities and C corporations?
For many years, the top C corporation rate and the top individual rate were the same — 35 percent; whether it was a C-corp or S-corp, the current tax paid was the same. That’s still the rate for C-corps. Now taxpayers are upset about higher tax rates for pass-through entities and want to know if it makes sense to become a C-corp.
Does it make sense to switch?
Some businesses may benefit, but if it made sense to be a S-corp before, the difference in the rates will likely not change things dramatically. Any significant business expecting a liquidity event down the road would not want to become a C-corp, even if tax rates are lower for the present, because it would be subject to corporate and individual taxes at sale. The detriment of the double tax can far outweigh the benefit of the lower rate now — it could result in 20 to 25 percent less in after-tax proceeds.
For example, a sale resulting in a $1 million capital gain would leave about $600,000 after the first level of tax, assuming a 40 percent combined federal and state tax rate. Then, the remaining proceeds would be taxed at the shareholder level, which could be another 33 percent — assuming a federal dividend/capital gain rate of 20 percent and state rate of 13 percent — or $200,000, leaving $400,000. If the business were a S-corp or partnership, there’s one level of taxation and the after-tax proceeds would be approximately $667,000.
Are there businesses that would benefit from a conversion to a C-corp?
Business owners have to weigh everything, including long-term plans. A S-corp business making $1 million a year that had paid $350,000 in taxes at 35 percent would now pay a 39.6 percent rate, and in some cases another 3.8 percent Medicare tax as part of the Patient Protection and Affordable Care Act. That 8.4 percent increase definitely makes an impact on a current basis every year. But does it make sense long-term to switch? If it’s a small business that’s never going to generate a large exit liquidity event or pay dividends, it may make sense to switch.
Other than avoiding the tax hike, would there be other reasons to change from a S-corp to C-corp?
One reason would be if the company decided to go public. Typically, any business remains a S-corp or a partnership right up until they go public. It’s expensive to switch back to being a S-corp, so it’s done only when everything is certain. When a C-corp is converted to a S-corp or partnership, there’s potentially a gain that’s taxed, if there are appreciated assets. Sometimes the tax cost is so great that businesses can’t switch and have to stay in a structure that is not optimal and/or desired.
That’s why businesses should be cautious about converting; it’s not something that is easily undone. There are also compelling reasons to be a S-corp in spite of the higher current rates. The 4.6 percent increase is just one factor, and it might not be the most significant one.
Alan Villanueva is a partner, Tax, at Moss Adams. Reach him at (949) 221-4046 or Alan.Villanueva@mossadams.com.
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