George Grzywacz of Doeren Mayhew

By George Grzywacz, CPA, JD – Shareholder, Doeren Mayhew

With the recent passing of new tax legislation, the main question on many S corporation owners’ minds is should they jump the fence to a C corporation. The simple answer, based on comparing the effective tax rates applied to the income generated by these entities alone, is likely not.

Assuming an S corporation’s distributable income and a C corporation’s taxable income are the same, even with the reduced 21 percent federal corporate income tax rate, the effect of taxing the C corporation’s income again when it distributes its earnings and profits in the form of a qualified dividend to its individual shareholders still results in an overall effective tax rate on that income of 39.80 percent. This rate is still incrementally higher than the newly enacted maximum individual income tax rate of 37 percent, leaving a beneficial rate differential of 2.8 percent by remaining an S corporation.

Additionally, if the S corporation qualifies to allow the shareholders to claim the newly enacted qualified business income (QBI) deduction at the full 20 percent of the S corporation’s distributable net income, the rate differential improves substantially with the effective income tax rate on the S corporation income reduced to 29.6 percent. This provides S corporation shareholders with a favorable rate differential of 10.2 percent.

State income tax expense can also have an effect on this rate differential. Take Michigan for example, the beneficial rate differential for a Michigan S corporation shareholder would be 5.32 percent without QBI and 12.72 percent with it. This takes into consideration that Michigan C corporations are taxed at 6 percent, while income from a pass-through entity is taxed at the individual’s rate of 4.25 percent. However, in states such as Texas, there are no taxes that would directly affect a conversion decision.

Other Considerations

Although the simple answer may be to remain an S corporation based solely on a lower effective tax rate, there are many other factors to consider in weighing this decision, such as:

  • Tax consequences of conversion
  • Treatment of tax attributes (i.e. research and development credit, loss carryforwards)
  • Alternative minimum tax considerations (no longer applies to C corporations)
  • Shareholder compensation
  • Use and distribution of accumulated earnings

In order get the right answer for your corporation, please contact Doeren Mayhew’s tax advisors to perform a tax structure analysis to best position the business and its shareholders.

Want to reach the author? Email George Grzywacz or contact him at 248.244.3415.