The majority of my business-oriented blog posts here take on a complex topic and re-frame the subject it in more simplistic terms for the purpose of opening a discussion from the perspective of small business management. This is exactly the purpose of this blog post. There is no attempt here to capture or even summarize the details of either S corporations or C corporation operations or the mechanical details of a conversion. We are only looking at the question of “Why might I want to convert?”
The topic of S corporations converting to C corporations surfaced shortly after passage of the of the Tax Cuts and Jobs Act (TCJA) in late 2017. Before that the topic was taboo. One tax lawyer even wrote to me last year that proposing it might be malpractice. Two weeks ago Craig Smalley, EA, a tax specialist who published an article on the topic wrote “my peers have called me crazy for encouraging an S- to C-corporation conversion”. Yet he has advised most of his clients to make the switch.’ Here in the greater Philadelphia region I have businesses using each business format. The key factors to consider are the amount and nature of earnings, the goals of the owner or investors. marginal tax rates of the individual owners, and applicability of Section 1202 rules for Qualified Small Business Stock. For many, the weight of influence is shifted under the TCJA.
The potential advantages of an S corporation that we focus on here are:
- benefit from the 20% exclusion of pass-through income
- Avoid duel level taxation at the corporate and individual taxpayer level
- Avoid wage taxes on a portion of the business earnings
On the other hand, the potential advantages of the C corporation are:
- Benefit from lower corporate tax rate of 21% that may be lower than the individual tax rate
- Tax-free health benefits
- Improved retirement benefits
- Avoid all tax on the sale of Qualified Small Business Stock
No doubt there are advantages and disadvantages to either strategy.
It appears that the S corp is preferable when a large amount of current income is being generated, the goal of the owner or investor is to withdraw and spend that income (often for normal living expenses) and the nature of the business allows the owner(s) to justify a significant dividend. Some portion is taxed at the individual tax rate and avoids wage taxes.
The C corp is preferable when the owner(s) or investor(s) plans to remain for at least five years and the structure of the business allows value to be built up within the business. Some portion of earnings may escape taxes altogether.
I welcome the opportunity to discuss the effects of either business format for your business.