Not operating as an S-Corp? You might be asking yourself why your closely held company is still being taxed as a C-Corporation when the opportunity exists to be taxed as a pass-through entity under subchapter S.
Overview of Corporate Taxation
Corporations that have not made an S election undergo double taxation. These corporations are known as C-corps. C-corps are taxed (1) at the entity level when the income is earned, and (2) at the shareholder level when the income is distributed.
They are taxed on worldwide income, including capital gains, at a maximum rate of 21%.
Taxable income is determined by subtracting allowable deductions from the corporation’s gross income. Gross income encompasses income from both US and foreign sources, such as business income, property gains, rents, royalties, interest, and dividends.
New Jersey taxes corporate profits at the top rate of 11.5%. However, this rate is expected to decrease to 9% beginning in 2024.
When the corporation makes an election to be taxed under subchapter S of the federal tax code, everything changes.
S-corporations are pass-through entities for taxation, meaning they typically don’t pay taxes at the entity level. Also, profits and losses are passed to shareholders, who report them on their personal tax returns, regardless of whether a distribution has been made.
For an S-corp election to be available, the corporation must be an eligible US entity and have a single class of stock. Stockholders can number no more than 100 and generally all stockholders must be US individuals (citizens or residents) (IRC Section 1361).
Impact of the Tax Cuts and Jobs Act on Corporate Taxation
The Tax Cuts and Jobs Act (TCJA) introduced reforms that have notably narrowed the gap in tax rates for individuals who own a business either through a C-corporation or a pass-through entity like an S-corporation, partnership, or LLC.
Prior to the enactment of the TCJA, and without considering state taxes, the tax structure was as follows:
Pass-through Entities: Individuals who earned business income through pass-through entities faced a top US federal income tax rate of 39.6%. If the business income was passive, an additional 3.8% net investment income tax was applied, bringing the total to 43.4%.
C-corporations: On the other hand, business income derived from a C-corporation was subjected to a more complex tax structure. Initially, the income was taxed at a corporate rate of 35%. When these profits were then distributed as dividends to individual shareholders, they faced an additional tax rate of 23.8%, which also accounted for the net investment income tax. This resulted in a combined top federal tax rate of 50.5%.
The TCJA made significant changes in the US federal income tax landscape for both C-corporations and pass-through entities such as S-corporations, partnerships, and LLCs. For example:
- Distributed Earnings: The effective tax rate for distributed earnings of a C-corporation was adjusted to 39.8%. This is broken down into a 21% federal tax at the corporate level and an additional 23.8% tax on dividends. The latter includes the 3.8% net investment income tax.
- Undistributed Earnings: For earnings that aren’t distributed, the tax rate stands at 21%.
Pass-through Entities (S-Corp, Partnerships, LLCs)
- Distributed Earnings: The effective tax rate ranges between 29.6% and 40.8%. This range is influenced by eligibility for the 20% deduction under IRC Section 199A, and the 3.8% net investment income tax’s applicability.
- Without the IRC Section 199A deduction, the top federal rate on regular business income for individuals is 37%. This rate can rise to 40.8% if the 3.8% net investment income tax on passive business income is applied.
- With the IRC Section 199A deduction, there’s a 20% deduction, leading to a 29.6% federal rate. If the 3.8% net investment income tax on passive business income is considered, the rate becomes 33.4%.
- Undistributed Earnings: The effective tax rate for pass-through entities, whether the earnings are distributed or not, remains the same, ranging from 29.6% to 40.8%. This is because owners of these entities are taxed based on the entity’s income, irrespective of whether income is distributed to the shareholders.
One of the pivotal reasons for businesses to operate as an S-corporation is the potential to qualify for the 20% deduction on qualified business income earned either directly or indirectly from pass-through entities, as per IRC § 199A. However, it’s crucial to note that as the law now stands this deduction will no longer be available for taxable years starting from January 1, 2026.
In essence, the TCJA’s modifications have made the tax landscape more favorable and balanced for individuals, regardless of whether they own a business through a C-corporation or a pass-through entity.
Reasons to make an S-Corp Election
Shareholders of a C-corporation might consider electing to be taxed as an S-corporation due to several potential advantages, which include:
Avoidance of Double Taxation
C-corporations face double taxation. First, the corporation pays tax on its profits at the corporate level. Then, when these profits are distributed as dividends, shareholders pay tax on them at their individual tax rates.
S-corporations, being pass-through entities, allow profits and losses to flow directly to shareholders’ individual tax returns. This means the income is only taxed once, at the shareholder’s individual rate.
Beneficial Tax Rates
Depending on the prevailing tax rates and the specifics of the TCJA or other tax reforms, the combined tax burden for S-corporation shareholders might be lower than that of C-corporation shareholders.
Shareholders of S-corporations might be eligible for certain deductions, such as the 20% qualified business income deduction under IRC Section 199A (though this is subject to various limitations and is not permanent).
Flexibility in Business Income
S-corporation shareholders can potentially classify a portion of their income as salary and another portion as a distribution. This can result in savings on self-employment or payroll taxes, as distributions aren’t subject to these taxes (though the IRS requires shareholders to pay themselves a “reasonable salary”).
If the S-corporation incurs a loss, shareholders can potentially deduct their share of the loss on their individual tax returns, subject to certain limitations. This can be beneficial for startups or businesses facing temporary downturns.
Simpler State Taxation
Some states don’t recognize the S-corporation election and will tax the corporation as a C-corporation. However, many states do recognize the S-corporation status and offer favorable tax treatment, reducing the overall state tax burden.
Estate Planning Benefits:
S-corporation status can offer advantages in terms of estate and gift tax planning, allowing for more efficient wealth transfers.
However, it’s essential to note that while there are benefits, there are also limitations and complexities associated with S-corporation status, such as restrictions on the number and type of shareholders and the requirement of a single class of stock. It’s crucial for shareholders to consult with tax professionals to understand the full implications and benefits of such a change.
How to Make an S-Corporation Election
For a C-corporation to transition to an S-corporation, it must promptly submit the IRS Form 2553. This submission should be made within two months and 15 days from the start of the tax year when the change is intended to be effective, as outlined in IRC Section 1362(b). Key corporate officers, such as the president, vice president, treasurer, chief accounting officer, or any other designated officer like the tax officer, must duly sign and date this form. A missing signature renders the form as not filed within the stipulated timeframe.
Furthermore, on the day the corporation opts for the S-corporation status, every shareholder must provide their consent. This agreement is documented in Part I, column K, titled “Shareholder’s Consent Statement” on IRS Form 2553, or an equivalent attached document.
Once the S-corporation election is made, it remains valid for that specific taxable year and all subsequent years, unless it’s terminated, either voluntarily or involuntarily, as per IRC Section 1362(d). In cases where the S-corporation status is revoked, the entity reverts to being a C-corporation. While the conversion from a C-corporation to an S-corporation is generally tax-free and doesn’t immediately impact the S-corporation or its shareholders, it’s crucial to be aware of potential tax implications.
Tax Traps to Avoid when Electing S-Corp Taxation
When a C-corporation transitions to an S-corporation status after its initial formation, commonly referred to as a converted S-corporation, the primary motivation is often to avoid the burden of double taxation. However, this conversion can introduce potential entity-level tax liabilities. Specifically, if the S-corporation sells assets that had appreciated in value during its tenure as a C-corporation, it may be subject to an entity-level tax on these built-in gains.
The BIG Tax on S-Corp Conversions
The built-in gains tax (BIG for short), is levied at the corporate rate of 21% as per IRC Section 1374.
The timeframe during which this tax can be imposed, termed the “specified recognition period,” has seen changes over the years. Initially set at ten years, it was temporarily shortened to seven years for the tax years 2009 and 2010. From 2011 onwards, this period was reduced to five years. It’s essential to note that the BIG tax is only applicable under specific conditions: it targets S-corporations that offload assets which had appreciated while they were C-corporations, and the tax is only on the appreciation value present at the time of the conversion.
However, there are scenarios where the BIG tax is not applicable. For instance, it doesn’t affect corporations that have always been S-corporations since their inception, even if they started with assets that had appreciated. Similarly, if a C-corporation didn’t have any appreciated assets at the time of its conversion to an S-corporation, the BIG tax won’t apply. Lastly, if the S-corporation holds onto its appreciated assets and only sells them after the specified recognition period (currently five years) has elapsed, it can avoid the BIG tax.
Passive Investment Income and Accumulated Earnings
In addition to the BIG tax, a converted S-corporation faces an entity-level tax in any tax year where its passive investment income, which includes dividends, interest, rents, royalties, and stock sale gains, surpasses 25% of its gross receipts, or where it retains accumulated earnings and profits from its C-corporation years at the end of the tax year, as outlined in IRC § 1375(a).
When an S-corporation incurs this specific tax, the corporate tax rate, currently at 21% as per IRC Section 1375, applies to its excess net passive income, as defined in IRC Section 1375(b)(1). This taxation diminishes the income amount that gets passed on to the S-corporation’s shareholders.
To sidestep this particular tax, the S-corporation has two options: (1) ensure its passive income remains below 25% of its gross receipts, or (2) distribute its accumulated earnings and profits before the close of its first S-corporation tax year.
However, shareholders will face taxation on this distribution at the standard income tax rates, according to IRC Section 1375.
If the S-corporation ends up paying this special tax for three consecutive years, it loses its S-corporation status.
Net Operating Losses
When a C-corp transitions to an S-corp, any existing unused net operating losses (NOLs) from its time as a C-corp present a notable limitation. Specifically, these NOLs cannot be applied to counterbalance the income of the new S-corporation, nor can they be transferred to the S-corp’s shareholders. This means that upon conversion, the unused NOLs from the C-corp phase typically become inaccessible.
However, there’s a potential exception: if these NOLs can be retroactively applied to a previous year when the entity was still a C-corporation, they might still be utilized. Otherwise, the NOLs risk being permanently forfeited.
If your corporation qualifies, there might be significant advantages to electing S-corp taxation. But you should be aware all of the pros and cons before making an election that carries tax consequences. If pass-through taxation is desired, it might be possible to convert your corporation to a limited liability company or other partnership. For more information on how this transition might be beneficial to your business, contact us today.