Recent Tax Law Changes Have Made This a More Difficult Decision
In creating a new business, one of the first decisions that an entrepreneur needs to make is which business structure is most appropriate for their business. The decision to be either a C Corp and S Corp needs to be addressed early as it is made before the company can be registered.
It is an important decision since the structure selected will affect everything from the amount of taxes which you may incur to how much of your personal assets will be at risk. Generally, given the liability protection offered by a corporate structure, most new entrepreneurs will choose between a C corporation or a corporation that has elected S corporation status. While both offer the same advantage of limited liability to owners, the tax impact of the two are very different.
C corporations are subject to two levels of taxes, with the corporation paying taxes on earnings it makes and then the shareholder paying another layer of taxes if dividends are paid to them. In contrast S corporations only pay one layer of taxes with the earning of the corporation flowing through to the owner(s) who directly pay the taxes. It is this one layer of tax which have made S corporation the business structure of choice for most small business owners looking to minimize taxes. This though could change given two fairly new tax law developments.
First, under the 2017 Tax Cuts and Job Act (TCJA), the highest corporate rate was reduced significantly from 35% to 21% making double taxation less of a disadvantage. Secondly, the 2015 Path Act tax legislation made permanent the ability to possibly exclude 100% of gain from the sale of a company acquired after 2010 if all other requirements are met. These new developments have made potential new business owners reevaluate the C vs S decision.
So which one is the best one for you? As with many decisions, it depends, but here are the top three questions to help you make the decision.
1) Do you plan to reinvest revenue back into the company or distribute it out?
If you plan to reinvest earnings back into the company than a C Corporation will likely be the right choice. If you plan to distribute most of the earnings you will probably save taxes by being an S corporation to avoid double taxation even given the reduced corporate tax rate. S corporations were also provided a tax break per the TCJA by receiving a maximum 20% deduction on qualified business income.
2) Do you intend to have foreign investors?
Foreign investors (non-U.S. Citizens or residents) cannot own shares in S corporation shares so if you intend to have foreign investors S corporation status may not be suitable.
3) Do you plan on selling your company? Will it be a stock sale?
In order for a stock to qualify as a qualified small business stock (QSBS), the company issuing the stock must be a C corporation. If you are planning to sell your company and meet the other requirements, you may be able to exclude 100% of the gain of company stock, and therefore, it could be quite beneficial to be structured as a C corporation. If your company does not qualify for QSBS status or you are only able to partially exclude the gain because stock of your company was acquired before, then you may be able to save taxes on a sale of a business by electing S corporation status and if the sale occurs 5 years after such conversion even if the sale is structured as an asset sale.
As outlined above, the selection of business structure is an important one. It can also be a challenging one given the different rules involved, and therefore, you should enlist help from a tax professional to help you make the right decision for your situation.