Previously, standard choice of entity decisions often entailed forming new entities as LLCs (or other entities treated as partnerships) and converting an existing C corporation to an S corporation.
Tax reform significantly reduced the C corporation tax rate to 21% and continues to allow C corporations to deduct state income taxes in full.
While tax reform also reduced individual income tax rates, the top individual tax rate remains 37%. It severely limits an individual’s ability to deduct state income taxes, resulting in a potential significant discrepancy in the income taxes owed by a business operating in a pass-through structure compared to a similar business operated through a C corporation.
The new 20% qualified business income deduction—which is available to individuals, estates, and trusts, but not C corporations—reduces this discrepancy to some degree but doesn’t eliminate it. Accordingly, many businesses operating in pass-through entities may be interested in analyzing whether they should convert to a C corporation.
Tax reform has greatly increased the complexity of choice-of-entity decisions. The reduction of C corporation rates to 21% has and will continue to, prompt businesses to examine whether they should convert to a C corporation.
Many business owners view the lower tax rate as an opportunity to retain more earnings to reinvest and grow their businesses, and are concerned about paying a higher tax rate than their competitors who are operating as C corporations.
While these are valid concerns—and potentially good reasons to convert to a C corporation—it’s important to assess whether these benefits outweigh the shareholder-level tax imposed on C corporations (but not on pass-through entities). Understanding how the shareholder-level tax will impact your total after-tax return requires understanding your future objectives—both for your business and personally.
When making this decision, there are three factors of consider: