2021 should bring big tax changes, but how much higher will they go and what exactly? First, think about where we are on this wild ride. The massive tax law that went into effect in 2018 radically changed many aspects of traditional tax planning. A prime example of the fundamental shift is the choice of unit for many small businesses. Corporations, partnerships, and limited liability companies (LLCs) are still eligible, but many tax incentives have changed. For generations, a company has almost always been the logical choice when an individual grew out of a company. In the past few decades, LLCs have become the new normal. They are typically taxed as partnerships, so the partners (or using LLC terminology, the “members”) pay taxes on the business income themselves. The flow-through tax treatment is still preferred, but will start with the complex but nifty pass-through deduction from 2018. But if you have or are starting a business, should it be an S or a C?
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Among other things, consider the qualifying Small Business Stock (QSBS) treatment, which applies only to C Corporation stocks. For small businesses that qualify – generally passing up to $ 50 million in assets and certain other tests – shareholders who have held their shares for 5 years may be able to exempt their profits from federal taxes. The shareholder limit is typically $ 10 million, and $ 10 million tax free would be nice! If you sell QSBS but haven’t held it for 5 years, there is another QSBS benefit. You can move the profit by transferring it to a new investment in QSBS. All in all, the QSBS rules can provide founders and other shareholders with enormous tax-free or tax-deferred benefits.
Of course, QSBS is just a problem. Additionally, if you read the QSBS rules carefully, you can conclude that your company is not eligible. That could bring you back towards S status. The articles of association do not state whether the company is an S or a C company. In fact, all companies are C companies (according to subchapter “C” of the Tax Code), unless they apply for the status of an S company. If you fail to take action to choose corporation tax treatment from the IRS, your company is a C corporation. An S choice has nothing to do with limited liability. Regardless of whether you have an S or a C, a company is entitled to limited liability. Limited liability is a traditional reason for starting businesses (although LLCs have limited liability as well). But in the C vs. S-Status is all about taxes. When you file a unilateral S election with the IRS, the company is taxed much like a partnership or LLC. You can change the status of your company, subject to restrictions.
A company can be taxed as C for many years and then move to S status. However, the conversion from S to C and vice versa is limited. If you switch too soon or too often, you will need to seek permission from the IRS. In fact, the tax code of S companies converting from C status imposes a kind of hybrid corporate tax. However, if you file an S election when the company is first incorporated (usually within the first 75 days after the company is incorporated), it will never be a C company. This way, the company and its shareholders don’t have to worry about the built-in profit tax that may apply to C to S conversions. So you can avoid this complication if the company files for S status from the start.
Income from a C company is taxed twice. The corporation pays taxes on its net income. Then shareholders also pay taxes on dividend distributions they receive. In contrast, income from an S company is taxed once at the shareholder level. From 2018, however, the corporate tax rate fell from 35% to 21%. That means C company status is way better, right? Not necessarily. Yes, the corporate tax rate is lower, but the individual tax rates have also been lowered. In 2018, the maximum rate fell from 39.6% to 37%. Additionally, many pass-through business owners (including S-businesses) can deduct 20% of their pass-through income. If you do the math, this reduces the highest effective tax rate from 37% to 29.6%. There are qualifiers and limits, but a tax rate of 29.6% sounds pretty good. 29.6% seems high compared to the corporate tax rate of 21% C, but it also takes shareholder taxes into account.
Dividends are usually taxed at 15% or 20% depending on your income level. With corporation tax and shareholder tax in mind, unless you keep all income in corporation, you’ll pay more tax on a C corporation, even at the new low corporate tax rate of 21%. An S company cannot have more than 100 shareholders, only US citizens and foreign residents as shareholders. The shareholders generally must be individuals (and certain limited types of trusts) and the company must generally have a calendar year. If there are several share classes, only differences in voting rights are permitted. And an S company can pay corporation tax if it was previously a C company and has chosen S status (the built-in profit tax) within the last 5 years.
How do you weigh the pros and cons of your facts? Typically, C companies are not the best choice for small businesses. The main reason is the double taxation of income and sales proceeds. However, a major benefit of C companies is the qualified treatment of small company stocks, which can bring shareholders tax-free only for companies up to $ 10 million. On the other hand, if you do experience losses, you’ll want to claim them personally, which benefits an S company, especially the pass-through tax break. Whatever you do, seek advice and pay attention to tax regulations. And watch out for post-election tax moves, whatever happens.