Many of you are wondering how the new tax rate changes will impact you. Obviously we can’t answer that off the top of our heads as each person’s situation is different, and in many cases experts are still trying to figure out how the changes will play out. One of the biggest changes is the corporate tax rate reduction to a maximum of 21% versus the maximum tax rate for individuals being around 37%.
The new tax legislation becomes effective January 1. That means many business owners are now considering whether to reorganize themselves as C corps.
Here’s why: Most U.S. small businesses currently don’t qualify for the reduced corporate tax rate. The majority of small enterprises are structured as pass-through entities such as limited liability companies or S corporations, where profits are taxed according to the owner’s personal rate. While there is some tax relief in the bill for those pass-through firms—including a temporary ability to deduct up to 20 percent of income—many could access the permanent cut by converting to full-blown C corporations.
It may technically be an escape clause, but experts say it’s one that startups are smart to take advantage of in 2018.
For those who wish to move quickly, the process of converting to a C corporation could theoretically take less than a week, provided your company is based in a state that allows for “statutory,” or streamlined, conversions. (The roughly 15 U.S. states that do not permit statutory conversions include Arizona, New York, and Pennsylvania.) There may be a number of hassles that could slow things down, though. Generally, you need to file a set of articles of incorporation with the secretary of state’s office; draft a series of corporate bylaws; and elect corporate officers and directors. You also need to hold annual board meetings and issue stock certificates.
Of course, owners are wise to consult lawyers and accountants before converting, which makes the process not so cheap. For that reason, it’s a good idea to measure out your potential savings ahead of time, or risk losing more money than if you retained pass-through status. “If you end up paying your lawyer bigger fees than your tax savings, you’ll wish you hadn’t done it,” warns Daniel Shaviro, a professor of taxation at New York University Law School. “Suppose there is only $20,000 at stake. If you convert to a C corporation, you’ll still only save a couple thousand dollars at most,” he adds. “On the other hand, if you’re playing with $100,000, 20 percent savings is worth it.”
Keep in mind that C corporations may be double taxed—once on the 21 percent preferential rate, and again if and when the owners pay dividends. William Kambas, a partner with the international law firm Withers Worldwide, does not generally recommend converting to a C corporation in the short term. “The two levels of tax would make a corporate operation less advantageous than a partnership,” he tells Inc. However, if you do not pay out dividends—and are rather planning to re-invest a majority of profits back into the business as part of a long-term strategy—”then I like the C corporation option,” he says.
Meanwhile, under the new tax code, “professional services”—which could encompass legal counsel, financial consulting or freelance design work, say—do not qualify for the pass-through deduction.
Some suggest that if your business generates income of less than $315,000, you are already insulated from having to pay higher taxes, since the pass-through deduction will generally apply. “If your annual gross income [AGI] is less than that, there’s probably very little you need to do as far as re-structuring,” Marcum’s Reitmeyer says. “You’ll have no deduction limitations.”
Another consideration: While the reduction to the maximum corporate tax rate is written as permanent, it could change, Reitmeyer points out. For instance, Democrats could retake a Senate majority, and vote through changes to the law. If that happens, it would be far more complicated to convert back to an S corporation or an LLC than the other way around.
Have a question? Contact Lisa Nason. Your comments are always welcome!