With the dramatic drop in the corporate tax rate to 21% and the introduction of the new 20% qualified business income (QBI) deduction for owners of pass-through entities, there has been growing focus on whether businesses should change their legal status to take advantage of new tax breaks.
Impact of a Change in Business Structure
Here is a brief overview of the consequences of changing entity status.
Going from S to C Status
An S corporation that wants to use the flat 21% corporate tax rate can revoke its S status and become a C corporation if the shareholders vote for it (at least 50% must agree). The revocation is effective on the date specified in a notice sent to the IRS. If the date is mid-year, then the corporation has two short years (one as an S and one as a C).
If there’s no date provided, then the revocation is effective as of the first of the year of the notice if received by the IRS on or before the 15th day of the 3rd month of the corporation’s tax year, or the first of next year if the notice is received later. For example, if a calendar-year S corporation files a revocation in September 2018 with no specified date, it will be effective on January 1, 2019.
Under a special rule, any accounting adjustment attributable to the revocation of S status can be taken into account ratably over six years beginning with the year of the change.
The caution here is that if things don’t work out as planned (e.g., Congress changes the tax rules again), the corporation usually cannot make a new S election for five years.
Going from Sole Proprietor to Corporation
Incorporating to gain the use of the flat 21% corporate rate usually can be done on a tax-free basis. And this gives the owner the non-tax benefit of personal liability protection.
But incorporating adds another level of tax administration, namely the filing of a separate corporate return (and likely other state-level obligations). And it makes the business subject to other tax rules applicable to corporations, such as the accumulated earnings tax that keeps the corporation from retaining too much income.
Going from Partnership or LLC to C Corporation
There’s usually no immediate tax cost for incorporating (taxes result only when partnership liabilities exceed partnership basis on the date of conversion). For owners, this means they become employees rather than self-employed individuals. They won’t be able to deduct any business expenses in 2018 through 2025 due to the suspension of the deduction for miscellaneous itemized deductions subject to the 2%-of-adjusted-gross-income floor.
Going from a C to an S
While the flat 21% tax rate is very attractive, some small corporations may want to think about making an S election. In this way, the owner-employee gets the same taxable compensation, but the business income may be taxed at a rate below 21%. For example, say the corporation is owned by one individual who is personally in the 22% tax bracket (for 2018 this is a single individual with taxable income up to $165,000). For such person, QBI would be taxed at an effective rate of 17.6%.
Keep in mind that QBI doesn’t include reasonable compensation paid to shareholder-employees. And this conversion usually is tax free, but assets can carry a potential “built-in gains” tax.
Going from Employee to Independent Contractor
Employees cannot use the 20% QBI deduction for their compensation. If your employee asks you to take him or her off the payroll to become an independent contractor, should you do it? Think long and hard before you act. The IRS will presume that a worker changing status from employee to independent contractor is still an employee unless proven otherwise. The usual worker classification analysis applies. So if the former employee is performing the same services and you control when, where, and how the work is performed, he or she is still an employee.
While it’s somewhat easy to understand the tax and administrative cost of making a change, it’s difficult to determine whether a change is advisable. There are many factors that come into play. If a change is contemplated because of tax reform, it may make sense to wait and see how the new rules will play out this year. Each situation is different so generalities are worthless. It’s imperative that you discuss this with your tax advisor for guidance in your situation.
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