For more than a decade, I (and probably you too) have typically advised small businesses to opt for a Limited Liability Company over a C corporation due to its ease of administration and tax advantages. However, the 2017 Tax Cuts and Jobs Act now creates the opportunity for big tax savings for C corporations and should make us rethink our general guidance.
We’ve got a full tax season under our belts since the Tax Cuts and Job Act was enacted. It’s a good time to take a fresh look at corporate structures and consider whether the C corporation is a better choice for your small business and startup clients. This can apply to clients who are launching a new business, as well as clients with existing businesses structured as LLCs or S corporations. Corporate structure doesn’t have to be set in stone — as circumstances change, maybe a business structure should too!
A quick overview of the C corporation, S corporation and LLC
Before we dive into the tax implications from the Tax Cuts and Job Act, let’s cover some of the basics of a C corporation, S corporation and LLC. This information may be common knowledge for many of you, but it’s always good to set the stage when discussing tax matters.
A C corporation is a type of company that is owned by shareholders and run by an elected board of directors. From a legal perspective, corporations are separate entities that can be sued and can sue. This means the corporation is responsible for its legal and financial liability, and owners are often shielded from personal liability (what’s known as the “corporate shield” or “corporate veil”).
In addition, corporations are considered separate taxpayers and pay taxes at a corporate tax rate. This can lead to “double taxation” with C corporations. The business’s income is first taxed at the corporate tax rate on the corporation’s tax return, and then can be taxed again on the individual’s tax return when dividends are distributed to shareholders.
Since individual tax rates were cut in the 1980s, the C corporation structure hasn’t made much sense for smaller businesses. In fact, there was little reason for smaller businesses to choose a C corporation unless they were going public or seeking VC financing. Instead, pass-through entities like S corporations and LLCs have been preferred. With pass-through entities, business owners can avoid double taxation since business income passes through to the individual’s tax return.
An S corporation is a C corporation that has elected pass-through tax treatment with the IRS. Like the C corporation, an S corporation is owned by shareholders and run by a board of directors. With S corporations and C corporations, you need to appoint a board of directors, hold an annual shareholders’ meeting and directors’ meetings, document key shareholder and director decisions, and file a separate corporate income tax return.
An LLC is a different kind of entity and combines elements of a sole proprietorship, partnership and corporation. As the name implies, the Limited Liability Company helps shield owners from personal liability (just like a corporation). But an LLC is much less complex to run and manage. LLCs typically just need to file an annual report with the state.
What makes the C Corporation more attractive now? The 2017 Tax Cuts and Jobs Act
The 2017 Tax Cuts and Jobs Act slashed the corporate tax rate from 35 to 21 percent. Combined with the additional benefits of IRC 1202, this lower corporate tax rate can now make the C corporation particularly attractive for some businesses.
IRC 1202 is a generous capital gains tax exemption that was championed by President Obama but hasn’t received much attention until now with the lower corporate tax rate. In essence, if you qualify for IRC 1202, you might be able to exclude 100 percent of the gain up to $10 million or 10 times your original investment. You need to hold the stock for five years, along with numerous other requirements.
As a result of the lower corporate tax rate and IRC 1202, the C corporation can now be extremely advantageous for entrepreneurs who launch a business and start small, plan to make profits and keep earnings within the company, and then cash out after holding the stock for five years or more.
Help your clients pick the right business structure
It’s impossible for a general article to provide a definitive answer on which business structure is right for your client’s specific situation (that’s where you come in). As you’re looking at potential business structures for clients’ businesses, here are a few factors to consider:
Does your client need to live off the business’ profits each year? For example, does your client need the business income to pay their mortgage, daily expenses, etc.? If so, taking money out of the corporation will trigger dividend taxes — and therefore, business profits will essentially be taxed twice. If your client is planning to put the business profits in his or her own pocket each year, a pass-through entity, like the S corporation or LLC, might be more advantageous.
Does your client want to keep paperwork and administration as simple as possible? Running a C corporation or S corporation requires more administration and paperwork than an LLC. If your client forms a C corporation or S corporation, make sure they are ready to spend more time keeping track of tax, business, shareholder and board records.
Does your client plan on holding the business for at least five years and then sell? If yes, the C corporation can be very advantageous — particularly if they will be keeping profits within the business until cashing out.
Does your client want to keep the business “forever”? Keep in mind that capital gains taxes are erased at death, so if your client never plans to sell the business, they may not need to bother with a C corporation/IRC 1202.
Is your client concerned about personal liability? Remember that one of the key reasons to form an LLC or corporation is the ability to minimize the personal liability and protect the personal assets of business owners from things that happen in the business. This holds true whether your client forms a C corporation, S corporation or LLC.
Steps to form a corporation
If your client thinks the C corporation is the way to go, here are the basic steps for them or you to follow:
1. Choose an available business name for the state.
2. Appoint the corporation’s directors.
3. Register the C corporation with the state, and draft and file the articles of incorporation. Your client can do this themselves or have you or an online legal filing service handle it.
4. Issue stock certificates to the initial shareholders.
5. Obtain the necessary local permits and business licenses.
6. Apply for an Employer Identification Number (EIN) with the IRS.
What about existing LLCs and S corporations?
Let’s say your client already has a business that’s currently structured as a pass-through S Corporation or LLC. After looking at the new corporate tax rate, you might decide that it’s now more advantageous for them to operate as a C Corporation. Here’s how to make the change:
- If your client’s business is an S Corporation, it’s easy to change to a C corporation. With majority shareholder consent, an S corporation can revoke its S corp election with the IRS. Depending on timing, the revocation may retroactively apply for the whole tax year, or they may need to split the tax year between S corp and C corp, and you can help them with this.
- If your client is currently an LLC and wants to restructure as a C corporation, their state may allow a statutory conversion (a very streamlined process). An alternative route is to create a C corporation and then merge the LLC with the C corp. This involves a bit more paperwork — but in some cases, the tax savings could be worth it.
A business structure doesn’t have to be set in stone. With the current changes to the tax law, this could be a good time to rethink the optimal business structure for new and existing businesses.
