Look Before You Leap from an S to a C Corporation

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It might be tempting for small business owners, and their advisors, to contemplate the higher tax rates on individuals spawned by the American Tax Relief Act, and conclude that switching their S corporation to a C corporation makes sense.

ATRA, passed to avert the fiscal cliff, raised tax rates for highest income individuals to 39.6 percent, alongside the 3.8 percent Medicare tax for married taxpayers with adjusted gross income over $250,000 ($200,000 for single taxpayers).

Since taxation of a C corporation is based on its earnings, while S corporation shareholders are subject to personal income tax based on the company’s earnings, it might make sense to be taxed as a C corporation subject to the lower corporate tax rate. Not necessarily so, said John Evans, CPA, a partner in the tax group at New York-based Marks Paneth & Shron LLP.

“The smart move will be to avoid that immediate, knee-jerk reaction,” he said. “You may think you’re lowering your tax obligations by being a C corporation and have the company pay the taxes at a lower rate. The reality is you’ll still probably save by remaining or becoming a flow-through entity such as an S corporation.”

There are a number of reasons why the owners of a growing company should retain its S designation, according to Evans.

“Double taxation of corporations is what I see most people miss,” he said.

Evans provided a few examples to illustrate the continued advantage of operating as an S corporation:

“Say an accrual basis company earns $1,000,000 in profit. If it’s a C corporation, it pays $350,000 in income taxes. Its shareholder also pay a 23.8 percent tax on the retained earnings when they are distributed, so there are two levels of tax that reduce the shareholders’ net cash distribution to $495,000. If the company is an S corporation, the income flows through to the owners, who pay as little as $396,000 in income tax. The S corporation owners are left with $604,000, or $109,000 more than the C corporation owners.”

Double taxation surfaces again if and when the business is sold, Evans observed.

“If it’s a regular corporation and it sells its assets, there is gain at the corporate level, and then tax is paid again when the proceeds are distributed to shareholders,” he said.

“Say a company finds a buyer for all its assets and one of the assets to be sold is self-created goodwill with a fair market value of $5 million and no tax basis,” he said. “If it’s a C corporation, it is subject to $1.75 million in corporate taxes. The remainder is distributed to the owners who must then pay $774,000 in capital gains tax on that amount.”

However, the result is more favorable if the company is an S corporation, Evans indicated. “In the case of an S corporation, the $5 million flows through to the shareholders as a capital gain and they pay $1 million in taxes. The S corporation owners are left with $4 million after taxes, while the C corporation owners are left with approximately $2.5 million—a savings of $1.5 million in taxes as a result of operating as an S corporation.”

As with all tax planning, people shouldn’t make quick decisions to change their entity based solely on tax rates, since the result may be different when they run the numbers.

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Tax planning