When the Tax Cuts & Jobs Act was enacted, I had many of my S corporation clients calling me to ask if they should switch to a C Corporation for tax purposes to take advantage of the new 21% corporate tax rate. While this may seem like a sweet deal, the following paragraphs will explain why C Corporations still don’t make a ton of sense for small businesses.
When you are an S corporation, you operate your company as a separate entity. You have income and expenses that are reported on a separate business tax return at the end of each year called an 1120-S. Although your business income is reported on a separate tax return, you don’t pay a corporate level tax. Instead, your business income flows through to your personal tax return and you pay individual tax rates on the income. These rates can be as high as 37% for 2020 depending on your income level.
The confusing part about the corporate tax cut that happened a few years ago is that it made the corporate tax rate significantly lower than the highest individual rate of 37%. This made many small business owners think they may be better off being treated as a C corporation for tax purposes and being taxed at the 21% rate, rather than rates as high as 37%. Here’s why this thinking is incorrect.
Let’s say a C corporation shows a profit on their corporate tax return of $100,000 for 2020. They pay a flat rate of 21% on corporate profits and are left with $79,000 after paying their taxes. Great!
But here’s what’s not great. If you own the C corporation, you can’t just take the remaining profits and do what you want with them. There are really only two ways for C corporation owners to take money out of the corporation. The first is a salary. Salaries are subject to social security taxes, Medicare taxes, federal income taxes, and state income taxes. Not great.
The other way to take money from the business is by issuing a dividend to the shareholder. When the corporation issues a dividend, the dividend is taxable to the shareholder. However, the corporation does not receive a deduction for any dividends paid. This means that the shareholder is paying taxes on money that has already been taxed at the corporate level, which is called double taxation. This is the biggest downside of owning a corporation.
The solution to this problem is to be treated as an S corporation. S corporations do not pay a corporate level tax. In addition, profits can be distributed to an S corporation owner via what are called sub-s distributions. These are similar to dividends, but they are not taxed at the individual level as long as the shareholder has sufficient stock basis in the corporation (meaning they don’t distribute more than the accumulated earnings of the company). So that means the S corporation profits are taxed at individual rates only, rather than corporate rates and individual rates. This is generally a better outcome, especially for small businesses.
One thing to keep in mind if you are an S corporation is that you have to take a reasonable salary. The government makes you take a reasonable salary because they want you to pay into social security and Medicare. Otherwise, you could just take all of your profits as sub-s distributions and only be subject to federal income taxes. Instead, let’s say you have $100,000 in profit at year-end before paying yourself any wages. A reasonable salary may be $50,000 (depending on your industry and specific role within the company). So $50,000 of your income gets hit with social security, Medicare, and income taxes. The other $50,000, however, is only hit with income taxes. This is generally a much better outcome for most small business owners.
So there you have it! S corporations still make sense despite the monstrous corporate tax cut from the TCJA. If you have more questions about entity selection, corporate taxes, reasonable salaries, or any other boring tax stuff, contact me! I’m happy to help.