In April, The Blackstone Group announced that it would no longer operate as a partnership. Instead, the venerable alternative asset manager would become a corporation, walking through a door Congress opened with the tax reform package it passed in 2017.
The Tax Cuts and Jobs Act of 2017 (often abbreviated TCJA) lowered the highest corporate income tax rate from 35% to 21%, making the switch from a pass-through entity such as a partnership more palatable. In the case of publicly traded private equity firms like Blackstone, the switch is not only meant to capture tax benefits, but to make stock more attractive to institutional investors like mutual funds.
Many observers expected a wave of C corporation conversions following the 2017 tax law. The Penn Wharton Budget Model, a research organization based out of the Wharton School at the University of Pennsylvania, predicted in June 2018 that about 17.5% of all ordinary business income from pass-through businesses would become corporate income due to conversions following tax reform.
If you own a pass-through business, such as a sole proprietorship, partnership, S corporation or limited liability company, should you join the crowd and convert it to a C corporation? It may seem like a simple question. After all, the highest individual income tax rate is 37%, while the corporate tax rate is now 21%, so the choice seems obvious.
In reality, the decision is not that simple. Many variables contribute to the question of the best structure for a particular business, and tax is only one piece of the puzzle. Beyond the tax consequences, you also need to have a solid understanding of your goals for your business in the long term.
In addition, the question of tax itself is more complicated than a simple comparison of potential tax rates. Any given business will need to run projections to see what business structure is the most beneficial under various circumstances. The same legislation that lowered taxes on corporations also reduced marginal income tax rates for most individual taxpayers and created a new 20% deduction on qualified business income. Given these factors, a pass-through structure may still be more tax efficient for many businesses. For others, a conversion could make sense.
There are a few questions you should ask yourself – and other owners, if you are not the sole equity holder – when deciding whether a C corporation conversion is right for your business.
Are profits going back into the business or are they being distributed to the owner(s)? A major traditional disadvantage of C corporations remains in place: double taxation. Each dollar of corporate income is taxed twice. The business pays corporate income taxes, and then shareholders owe tax on dividends received from the business. Qualified dividends are taxed at rates between 0% and 20%, while nonqualified dividends are taxed as ordinary income. Say a business earns a dollar in profit and distributes it as a dividend to its owner, who is subject to the 15% dividend tax rate. The corporation first pays 21 cents to the government, leaving it 79 cents to pay out as a dividend. After the dividend tax, the government is taking almost 33 cents of that original dollar. (I am ignoring state income taxes for the sake of simplicity in this example.)
When you consider dividends, the effective C corporation tax rate for most business owners winds up somewhere between 32.8% and 36.8%, if you assume a tax rate on dividends of 15% and 20%, respectively. These rates could be higher than the marginal rate an owner would apply to their business income from a pass-through structure. In a worst-case scenario, the effective tax rate could be nearly 40% when you factor in both double taxation and the net investment income tax of 3.8%. This means that if a substantial portion of the profits from your business is paid out to you, along with any other partners or owners, double taxation may undermine any benefits of switching to a C corporation structure.
This is not to say that a C corporation conversion is always the wrong answer if you plan to distribute profits regularly, but double taxation will be a key consideration when you (and your tax adviser) run the numbers. On the other hand, if you plan to retain all or most of the business’s earnings to reinvest in the firm itself, the second layer of tax on dividends matters much less. If your business plans to retain all profits, your effective tax rate will be 21% – a clear advantage for most business owners, even in light of the potential 20% deduction for qualified business income. In this case, conversion may be much more attractive, because the corporation’s owners can accumulate profits at a much lower effective tax rate than they could if the business were structured as a pass-through entity.
If your business generally operates at a loss, you can deduct losses from a pass-through entity on your personal return to offset other sources of income, an advantage not available to owners of C corporations. However, the TCJA placed limitations on the amount of income that can be offset by a net operating loss from a taxpayer’s active trade or business operated as a pass-through entity. For tax years starting after Dec. 31, 2017, the law implemented an “excess business loss” limitation. An excess business loss is the excess of either the aggregate deductions from an individual’s trades or business, or the sum of aggregate income from these businesses plus a set dollar amount ($250,000 for an individual or $500,000 for a couple filing jointly). For example, if a business operated by a single taxpayer generates a net loss of $300,000, the taxpayer will be limited to deducting up to $250,000 against other income. Assuming the taxpayer has enough other income (wages, interest income, capital gains, etc.) to use up the allowed loss, the additional $50,000 of losses will be carried forward as a net operating loss to a future tax year. The excess business loss limitation, like many parts of the tax reform package, will expire at the end of 2025 unless Congress renews it.
Is my business a “specified service business” according to the Internal Revenue Service? Pass-through business owners can pay up to 37% on their income if they occupy the top individual tax bracket. However, if they qualify for the 20% pass-through deduction, they will instead pay an effective rate of 29.6% on business income. This can help level the playing field, especially when you factor in the double taxation question for C corporations.
However, qualifying for the deduction can be a complicated prospect for some owners. Lawmakers set an income threshold for taxpayers claiming this deduction. Above this level – $157,500 for single taxpayers or $315,000 for married couples filing jointly – the deduction is limited or completely phased out for specified service businesses. These are enterprises where the main asset is the reputation or skills of the owner or employees. The full rules surrounding qualified business income are beyond the scope of this article. However, my colleague Anthony Criscuolo recently wrote about this topic. Owners who want to know whether it makes sense to restructure their businesses as C corporations need to be sure that they understand the rules about who can take the qualified business income deduction and under what circumstances. Specified service businesses, especially high-income businesses, will likely see less benefit from the deduction, making a potential conversion more attractive.
Do I want to secure outside investment – and, if so, how? A business planning a capital expansion may benefit from converting to a C corporation, because C corporations offer special benefits to shareholders. Certain C corporations can issue “qualified small business stock.” If such stock is retained for five years, shareholders can entirely avoid capital gains tax under Section 1202 of the tax code. Many states also follow this provision. This benefit, unique to C corporations, can make your company’s stock more attractive to potential shareholders.
Attracting venture capital is also easier for C corporations, which is why many tech startups favor this structure. Most venture capital arrives via a venture capital fund, in which a fund manager directs pooled investments from various investors. Venture capital investors tend to favor the governance structure, as well as the legal and liability protection, offered by C corporations. If your business wants to attract venture capital, being a structured as a C corporation is essential.
S corporations, in particular, face challenges in raising capital because of limits on who can own their shares. They are limited to 100 total shareholders or fewer, and partnerships and certain trusts cannot own S corporation stock at all. Most foreign taxpayers cannot be shareholders, and other corporations can’t invest either.
As I mentioned earlier in this article, public partnerships like Blackstone may also find conversions especially attractive since the change in tax law reduced the corporate tax rate. C corporation stock is generally easier to trade and can be included on more indexes. This can create real benefits for a company.
Where do I live? Congress capped the state and local tax deduction for individual taxpayers at $10,000 per year. This cap also applies to property taxes. If you live in a high-tax state, you can no longer expect the full federal tax benefit you used to receive for paying these taxes. C corporations, however, can still fully deduct state taxes.
What sort of benefits do I plan to offer? C corporations can provide certain tax-free fringe benefits to shareholder-employees that are not available to some pass-through businesses. Instead, partners, LLC members and S corporation shareholders who own 2% or more of the business’s stock have to include the benefits in their income. C corporations may set up “cafeteria” plans, in which employees are reimbursed for expenses such as group term life insurance premiums, accident and health benefits, qualified transportation costs and adoption assistance.
As I mentioned earlier, C corporations also offer a benefit to qualified small businesses in the form of Section 1202 stock. This provision allows shareholders to exclude capital gains on company stock under certain circumstances. This can be attractive to employees if you offer stock as part of their compensation package.
This is not to say that C corporations are the only structure with advantages. Some businesses strategically operate as S corporations in part to minimize Social Security and Medicare taxes. This strategy involves paying modest salaries to employees who are also shareholders in the S corporation. The shareholders can then take tax-free distributions – assuming their stock has adequate cost basis – if they need additional funds from the business. The TCJA makes this strategy even more attractive, since passed-through S corporation income is potentially eligible for the qualified business income deduction. In this situation, remaining an S corporation may make sense. Note that the IRS requires that S corporations pay their employees a “reasonable” salary. If the IRS determines that the salary paid was not reasonable, they could reclassify distributions as wages.
Do I have the resources to deal with complex compliance requirements? Generally, C corporations involve more complex compliance than pass-through entities, and thus increased compliance costs. They can be more expensive entities to maintain, because you may need to pay professionals to handle the governance and other legal requirements they entail.
Can I handle the other tax consequences of conversion? If your business holds important assets that are likely to appreciate in value – such as real estate – converting to a C corporation is likely not the best choice. It may be impossible to realize the gain on such assets without double taxation. Once you have converted to a C corporation, switching back can entail serious tax consequences. Taxpayers should also bear in mind that converting your pass-through entity to a corporation can cause you to recognize taxable income if the conversion does not qualify for an exclusion under the tax code (such as the exclusions described in Section 351 or Section 357). Owners should take care to ensure the transaction is structured properly to minimize the recognition of income.
The conversion from an S corporation to a C corporation creates special concerns. If you terminate the S election, generally your business cannot make a new election for five years, locking you into your new structure for at least that long. Companies that restructure as C corporations are effectively betting that the corporate tax rate will stay low. This is not an unreasonable bet. Unlike many other provisions of the new law – including the qualified business income deduction – the reduction in the corporate tax rate is “permanent.” However, nothing is ever truly permanent when Congress is involved. Lawmakers could always pass new legislation in the future to change the tax rules.
Changing from an S corporation to a C corporation can also entail certain tax consequences in the short term. Under particular circumstances, S corporations that change from the cash method of accounting to the accrual method of accounting after revoking their S election either can or must take into account certain adjustments related to Section 481(a) of the tax code. Depending on the timing, this can create complications for the tax year that the entity restructured. The full details are beyond the scope of this article, but I mention these rules to emphasize that changing from an S corporation to a C corporation is a complicated maneuver that should be handled with the help of a tax professional.
This article has merely scratched the surface of the complications that could influence an individual owner’s choice to convert his or her pass-through business to a C corporation. Due to the complexity involved, it is best to involve a tax expert in your decision and to take care to provide thorough and accurate information when you do. The answer to the best business structure depends on how you envision your business’s future, as well as its size and your industry. The recent change to corporate taxation means that it is well worth asking whether a conversion is a good fit for your particular enterprise.