New tax law is driving a new debate about corporate form selection

Whether you agree with President Donald Trump that the recently passed tax act is the biggest tax cut in history, the new law is radically reshaping some traditional tax planning. A prime example is choice of entity for many small and not-so-small businesses. Corporations, partnerships and limited liability companies are still in the mix, but many tax incentives have changed. And the choices now are less obvious.

A few decades ago, when an individual outgrew a proprietorship, a corporation was almost always the logical choice. In more recent decades, LLCs became the new normal. They are generally taxed as partnerships. That means the partners (or using the terminology of LLCs, the "members") pay taxes on the business income themselves.

Flow-through tax treatment of this sort is still favored, but under the new tax law, now even more so. That suggests that many businesses will still be formed as LLCs, partnerships or S corporations. But if you have a corporation -- one that you formed or inherited -- should it be an S or a C corporation? Once you decide, can you readily change what type of corporation you have?

More generally, what does this alphabet soup of corporate tax status really mean? Articles of Incorporation filed with your state's secretary of state are the corporation's birth certificate. However, these articles do not say if the corporation is an S or a C. All corporations are C corporations (under subchapter "C" of the tax code) unless they file for S corporation status.

If you take no action to elect S corporation tax treatment from the IRS, your corporation is a C corporation. An S election has nothing to do with limited liability. Whether you have an S or a C, a corporation is entitled to limited liability. Limited liability is one traditional reason that businesses incorporate (although LLCs are also entitled to limited liability).

Corporations are structures that people understand. A corporation is a separate legal entity, owned by shareholders, and ruled by a board of directors, who elect officers to do day-to-day management. But C vs. S status is all about taxes. If you file a one page S election with the IRS, the corporation will be taxed almost like a partnership or LLC.

Subject to limits, you can change your corporate states. A corporation may be taxed as a C corporation for many years, and then change to S status. There are some special rules and limits on converting from S to C, and vice versa. If you change too soon or too frequently, you must ask the IRS for permission.

In effect, the tax code imposes a kind of hybrid corporate tax on S corporations that convert from C status. However, by filing an S election upon the initial formation of the corporation (generally in the first 75 days of the corporation's formation), it will never be a C corporation. That way, the company and its shareholders do not need to worry about the built-in gain tax that can apply to conversions from C to S. So, you can avoid that complication if the corporation files S status from the beginning.

Income from a C corporation is taxed twice. The corporation pays tax on its net income. Then, shareholders also pay tax on dividend distributions they receive. In contrast, income from an S corporation is taxed once at the shareholder level.

This is one place where there are big changes. The new tax law radically cut the corporate tax rate paid by C corporations from 35 percent to 21 percent. That means C corporation status is much better, right? Not necessarily.

It is true that the corporate tax rate is now much lower. But, compare even that 21 percent rate to how an S corporation is taxed. Individual tax rates were also cut by the new law. Now, the top rate dropped from 39.6 percent to 37 percent. What's more, owners of many pass-through businesses (including S corporations) can now deduct 20 percent of their pass-through income.

If you do the math, that reduces their top effective tax rate from 37 percent to 29.6 percent. There are qualifiers and limits, of course. But for many, the idea of a 29.6 percent tax rate sounds pretty good. You might think that 29.6 percent seems high compared to the 21 percent C corporation tax rate.

But one must consider the shareholder level taxes as well. Dividends are generally taxed at 15 percent or 20 percent, depending on income levels. Considering the corporate tax and the shareholder tax, unless you leave all income in the corporation, you end up paying more in taxes with a C corporation, even at the new low 21 percent corporate rate.

There are eligibility rules for S corporations. An S corporation can have no more than 100 shareholders, only U.S. citizens and resident aliens as shareholders. The shareholders must generally be individuals (and certain limited types of trusts), and the corporation must generally have a calendar year. If there are multiple classes of stock, only differences in voting rights are allowed. For most small businesses, these criteria are easy to meet.

If the owners are more comfortable with the corporate form than with an LLC, an S corporation can be a good choice. However, the accounting rules for S corporations are more complicated. Moreover, converting from C to S can be nuanced. An S corporation can face corporate tax if it was previously a C corporation and elected S status within the last five years (the built-in gain tax).

How do you weigh the pluses and minuses on your facts? Usually, C corporations are not the best choice for small businesses. The main reason is the double tax on income and on the proceeds of sale. Besides, if you incur losses, you want to claim them personally. That will favor an S corporation.

That is especially true with the new pass-through tax break. All in all, there seems to be an uptick in interest in S corporations. And yet some people are lured by that low 21 percent C corporation tax rate. Whatever you do, get some advice, and pay attention to the tax rules.