Tax Law Prompts S Corps to Examine Their Structures: A Primer(1)

For over 50 years, Bloomberg Tax’s renowned flagship daily news service, Daily Tax Report® has helped leading practitioners and policymakers stay on the cutting edge of taxation and...

By Laura Davison

Businesses are considering whether their corporate structures make the most sense in light of the new tax law, which changes the effective tax rate for many companies—depending on industry, kind of structure, and location.

That question can be especially difficult for closely held, usually family businesses that are often structured as S corporations. These entities, along with other pass-throughs such as limited liability companies and partnerships, flow their income through to their investors, who pay the tax.

S corporations are beginning to model out how the new tax law will affect their businesses, tax professionals told Bloomberg Tax. The new law likely won’t result in a mass conversion from pass-through to C corporation status, but the changes are significant enough for every business to take a look at what makes the most sense for them, the practitioners said.

Here are some things to question as the new tax act (Pub. L. No. 115-97) takes effect.

How Much Income Qualifies for 20 Percent Deduction?

The new tax law provides a 20 percent deduction for pass-through entities, including S corporations. But the tax break, in tax code Section 199A, phases out for service companies like medical practices and consulting firms beyond certain taxable income levels—$157,500 for individuals, $315,000 for joint filers. The deduction is also limited by how much the company pays in wages to employees.

Knowing how much income will be subject to the deduction is critical to determining whether it’s advantageous to be an S corporation, Kevin Anderson, a partner in the National Tax Office of BDO USA LLP in Washington, told Bloomberg Tax.

“If we just assumed that all S corporation shareholders would be subject to the maximum rates of tax and assume all their income is eligible for 20 percent deduction, it’s fair to say it’s advantageous to be operating as an S corporation,” Anderson said.

But many companies will find that the deduction is more limited, either because not all their income is considered to be qualifying business income or because they don’t pay enough in wages. Companies need to model out how the deduction will apply in their specific cases to know what their effective tax rate will be, he said.

Is an S Corp the Best Business Structure?

Once an S corporation knows what its effective tax rate likely will be, it can compare it with the new regime for C corporations.

The new tax law lowers the corporate tax rate to 21 percent from 35 percent, a large reduction that is causing S corporations to reconsider whether they should convert to being taxed as C corporations.

“People are still in the figuring-it-out phase,” said Laura E. Krebs Al-Shathir, counsel at Capes, Sokol, Goodman & Sarachan, PC in St. Louis, Mo. “I haven’t helped anyone walk through the conversion process and I’m not even sure I’d advise a new business to form as a C corporation. I’m not seeing people convert. I’m seeing people think about it.”

Companies need to think about how much of their earnings they plan to distribute to their shareholders. While corporations will pay a 21 percent income tax rate—and pass-through owners will pay about 29.6 percent, depending on their tax bracket and the type of income—corporate distributions will still be taxed.

“The biggest determinant on if you should go to C is how much of the profits you expect to distribute as dividends,” said Mel Schwarz, director of tax legislative affairs in Grant Thornton LLP’s National Tax Office in Washington. “If you’re going to distribute all the profits as dividends as a C corporation, your tax rate is going to be higher than if you are a pass-through.”

The distribution policies can vary widely among family businesses, said Bryan Keith, managing director in Grant Thornton’s National Tax Office. S corporations will need to consider whether there are family members who are used to getting distributions each year or if there are trusts that have distribution requirements, he said.

Owners considering moving to a corporate structure should be aware of the accumulated earnings tax, a 20 percent tax on companies holding on to too much cash, and the personal holding company tax, another 20 percent penalty on undistributed passive income earned in a closely held C corporation.

Companies should also consider whether they expect losses in the future, Krebs Al-Shathir said. If you stay a pass-through those losses can flow through to the owners and offset other types of income, she said.

When Can a Company Choose Not to Be an S Corporation?

A company must choose to revoke a subchapter S election by March 15 to have it apply for the whole year if it is a calendar-year taxpayer. (If it has a different tax year, the company needs to make the election by the 15th day of the third month of the year.)

But if a company decides midyear it’s no longer advantageous to be an S corporation, it can make the election at that point and have it be effective from that point onward, Anderson said.

If a company elects to terminate its S corporation status, it can’t reapply for S corporation status for five years.

“My initial recommendation is that S corporations ought to sit tight and be patient,” Anderson said.

Are There Plans to Sell or Acquire Another Company?

If there are any plans to sell the company in the near future, it makes sense to stay an S corporation because it’s much easier to sell a company with a single layer of tax, Schwarz said.

Even if there aren’t immediate plans to sell the company, unexpected situations can arise, he said.

“A lot of these are family companies,” he said. “Private planes can fall out of the sky and the family is not in a position to continue the biz. Or people come and they offer more money than you’ve ever dreamed of for the business.”

Asset sales, as opposed to stock sales, are particularly attractive for S corporations looking to sell or to buy another company. Buying the assets allows the owners to depreciate the property, which is even more beneficial under the GOP tax plan, which expands expensing provisions.

Acquiring the assets of a pass-through entity allows the buyer to avoid the second layer of tax they would trigger if they were buying a corporation’s assets. Deals involving corporations require the buyers to pay tax on the entity-level gain and for the shareholders to pay tax on the distributed earnings.

What About International Operations?

While many of the territorial international tax provisions in the new tax law don’t apply to pass-throughs, Schwarz said there is one big advantage: S corporations can defer the tax on unrepatriated earnings as long as they keep their status. If you convert to a C corporation, it will trigger that tax, he said.

Request Daily Tax Report®