taxes

Is It Time to Switch Your Business to a C Corporation?

S firm owners face some decisions in light of new tax rates.

For the first time in more than a decade, the highest personal tax rate tops the corporate rate. The maximum tax rate on individuals is now 39.6% for joint filers with taxable income over $450,000 and single filers above $400,000, while the top rate on corporations remains unchanged for 2013 at 35%. S firm owners are wondering if this means it is time for them to switch to a regular corporation. But after examining the options, the tax rate differential usually isn’t a large enough factor to warrant being taxed as a regular corporation.

The key disadvantage to being a regular corporation (what tax pros call a C corporation) is that C corporations still bear the burden of double taxation. Their profits are hit with corporate tax and shareholders pay tax on dividends distributed to them. That can push the effective tax rate above 50% on dividends paid to owners. The profits are taxed to the corporation at as much as 35%. If the firm’s shareholders are in the 39.6% individual tax bracket, they will pay a 23.8% tax on the dividends, including the new 3.8% Medicare surtax. If a shareholder is in a lower tax bracket and pays just a 15% tax on dividends, the effective rate is 44.75%. S firm shareholders owe income tax on the firm’s profits at a marginal rate of up to 39.6%, plus 3.8% for owners who aren't active in the business and are subject to the Medicare surtax. So if dividend payouts are planned, S corporation status remains less taxing.

C corporations also face a tax disadvantage when they are sold. In most cases, buyers want to do the acquisition as a purchase of the firm’s assets, rather than buying the corporation’s stock. That gives them a higher income tax basis in the acquired assets, allowing for greater depreciation and amortization deductions. Asset sales by regular corporations draw two layers of taxation. The gains are taxed at the corporate level at ordinary income rates, not the favorable low rates for individuals, and then at up to 23.8% when the after-tax proceeds are distributed to shareholders. That compares unfavorably to the usual single level of taxation on asset sales by S firms, except for the 35% built-in-gains tax, which hits corporations that convert to S status and sell assets at a profit within five years after switching.

However, S firm owners should note that there’s talk of lowering the top corporate rate to 25% as part of tax reform, although 28% is probably more likely. On its face, that would seem to significantly favor C corporations. But tax reform won’t be done in a vacuum. Individual rates will be cut, too. Otherwise, proprietors, partners and S firm owners would face a huge tax increase, as business breaks they use would be trimmed to pay for lower rates on corporations. There is no chance lawmakers are going to allow that result to happen. Thus, most S corporation owners will benefit from retaining their S company election.

Most Popular

Planning to Sell Your Home in Retirement? Downsize Costs Along With Space
Budgeting

Planning to Sell Your Home in Retirement? Downsize Costs Along With Space

In this hot real estate market, consider the costs of buying and selling a house along with the expenses associated with your new digs.
November 13, 2020
What Biden Will Do: 24 Policy Plays to Expect From the Next Administration
Politics

What Biden Will Do: 24 Policy Plays to Expect From the Next Administration

The Kiplinger Letter forecasts President-Elect Joe Biden’s biggest priorities -- and the likelihood of progress on them.
November 19, 2020
The 13 Best Healthcare Stocks to Buy for 2021
Kiplinger's Investing Outlook

The 13 Best Healthcare Stocks to Buy for 2021

Most of the best healthcare stocks for 2021 will have some sort of ties to COVID, whether it's producing a vaccine or cure, or benefiting from the vir…
November 20, 2020

Recommended

Are You Liable When a Customer’s Hummer Gets Stolen from Your Parking Lot?
small business

Are You Liable When a Customer’s Hummer Gets Stolen from Your Parking Lot?

A motel stay led to an unfortunate loss for a California couple. Can they hold the motel responsible? A lawyer’s take on the situation may not leave t…
November 25, 2020
10 States with the Highest Gas Taxes
taxes

10 States with the Highest Gas Taxes

COVID-19 has made us appreciate driving our cars more, but filling up the tank will cost you more in these state.
November 23, 2020
10 States With the Lowest Gas Taxes
taxes

10 States With the Lowest Gas Taxes

Saving money is a marathon not a sprint. And even low gas taxes can help keep money in your pocket.
November 21, 2020
Election 2020: States With Tax Questions on the Ballot
Politics

Election 2020: States With Tax Questions on the Ballot

On November 3, voters in 17 states weighed in on a variety of proposed changes impacting taxes on everything from property to pot.
November 19, 2020