With special thanks to Mariya Luqmani, CPA, MST, President of MLCPAS Inc specializing in business and international taxation, for her contributions to the article.
Lately a lot of my small-business clients have been asking me about C corporations. I understand why. The Tax Cuts and Jobs Act (TCJA) has bestowed a very preferential 21% flat tax rate on corporations, replacing the previous graduated tax rate of 15% to 35%.
Does converting to a C corp make sense for you? Since the graduated rate was based largely on taxable income, the simple answer would appear to be to determine whether your company's taxable income is closer to the 15% mark (in which case converting would be a bad idea) or the 35% mark (in which case converting could be a great idea).
But as with most simple answers, the reality isn't so simple. This is particularly true of businesses that are still in the planning stages, where projecting the bottom-line taxable-income numbers is just that — a projection.
So what's a small-business owner to do?
Catch 22: The New Flat Rate Comes with Strings Attached
A careful review of business and individual income is needed at each level to determine the most beneficial entity structure in light of the TCJA. This is because in 2018 and going forward, corporate-loss carryforwards from prior years can only be deducted up to 80% of current-year income.
For example, if there is a loss of $10,000 in 2018 and an income of $8,000 in 2019, the corporation can only deduct $6,400 (80% of $8,000) in loss from 2018. It will still have to pay tax on $1,600 in income. This restriction doesn't apply to individuals.
The general takeaway is this: With the new tax laws, tax planning ahead of time is the only way to optimize savings in tax dollars.
A Quick Pass Through Pass-Through Entities
Rather than fixate on the flat-tax provision, the real issue small-business owners should consider is whether or not they would benefit from "pass-through entity" status.
Conducting business as a pass-through entity — e.g. a sole proprietorship, partnership, LLC or S corp —means you're subject to an individual income tax rather than a corporate income tax on the business itself. At a C corp, the owners still have to pay personal income tax of 15% on dividend distributions from the corporation. The corporation pays a corporate income tax as well.
The devil lies in the details. To make a meaningful comparison, small-business owners have to weigh the impact of switching to a C corp on their individual returns as well as their corporate returns. Will paying less in corporate income tax result in paying more in individual income tax? That's the real question.
And That's not All …
You must weigh other factors beyond various tax rates when comparing different business structures, including liability issues. That's why, whether you are just starting a small business or have been operating one for years, it's critical to focus on the big picture and not be seduced by the prospect of huge tax savings that could well prove to be a mirage. Before making such a critical decision, consult a CPA or other qualified tax professional.