I can still remember my first day of Corporate Taxation class in college. We were beaten over the head with the concept that small businesses (i.e., those grossing less than $25 million) should never elect to be taxed as a C-corporation.
The argument then was that C-corps had a tiered tax structure and could be taxed as high as 35 percent. There was also the problem of double taxation, and, upon audit, there could be an accumulated earnings tax on any monies not distributed to shareholders.
It was a compelling argument that stuck with me for many years, until the TCJA capped the tax on C-corp profits at 21 percent. There was also the later IRS guidance regarding previously undistributed and taxed profits from the time the company was an S-corp or partnership. Moreover, upon conversion, and without consent from the IRS, a company could change its method of accounting.
As I’ve mentioned previously, my peers have called me crazy for encouraging an S- to C-corporation conversion, which I’ve done for 95 percent of my clients. I was told I set them up for double taxation, and, with the new Section 199A deduction, it was just insane to convert.
Despite this negative feedback, I am happy to say that since the subsequent guidance issued by the IRS regarding conversions and the fact that most of my clients don’t benefit from the Section 199A deduction due to adjusted gross income (AGI) limitations, I believe I made the right decision.
Let’s examine an S-corp for a second. In theory, the owner of one is paid reasonable compensation, and then the shareholders distribute the remainder of the profits amongst themselves. I implore you to take a minute and ask your clients what they do with those distributions. Most will buy health insurance (which is not deductible if they have a share that’s larger than two percent), put money in a health savings account (HSA) and pay other medical expenses.
I devised a plan whereby double taxation never comes into play,
As I just stated, a more-than-two-percent shareholder is not allowed to have fringe benefits. Upon a company’s conversion to a C-corporation, however, these shareholders can have health insurance, contribute as much as they want to a health reimbursement account (HRA), get a company car and obtain other, non-taxable fringe benefits they could not have as an S-corp owner. The restrictions are stifling, to say the least.
Now, let’s examine retirement plans. Shareholder(s) with employees can start a Safe Harbor 401k. Their salary deferrals can go to the Roth option of the 401k, as their personal tax situation is less because there is no flow-through of S-corporation earnings.
On top of that, they can contribute 25 percent of their salary to the plan, while contributing only three percent to their employees. Additionally, if they are a high wage earner, they can start a Defined Benefit Plan (DBP) whereby they can contribute up to $225,000 to it (depending on their age and actuarial table). They can couple that with a 401(h), which is for healthcare expenses when company owners retire, and contribute just as much as they do to the DBP.
Then, the IRS handed us a gift. After an S- to C-corp conversion, any previously taxed income that was left in the S-corp can be taken out tax-free and added to the Accumulated Adjustments Account (AAA). They have two years to take this money. Furthermore, the method of accounting can be changed from cash to accrual and vice versa without filing Form 3115. Further, in the conversion to a C-Corp, the stock of the corporation can be classified as Section 1202 stock, the first $10 million of which is tax free if it’s held for five years before being sold.
I will admit that the conversion is not for everyone. For example, if a partnership or S-corporation has an appreciable asset, such as a building, it would make no sense to convert to a C-corporation because these don’t allow for a favorable capital gains tax situation if the property is sold.
Although the decision needs to be on a case-by-case basis, there are many reasons to convert to a C-corporation.
About Craig W. Smalley, EA
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as representation before the IRS regarding negotiations, audits, and appeals. In his many years of practice, he has been exposed to a variety of businesses and has an excellent knowledge of most industries. He is the CEO and co-founder of CWSEAPA PLLC and Tax Crisis Center LLC; both business have locations in Florida, Delaware, and Nevada. Craig is the current Google small business accounting advisor for the Google Small Business Community. He is a contributor to AccountingWEB and Accounting Today, and has had 12 books published on various topics in taxation. His articles have also been featured in the Chicago Tribune, New York Times, Yahoo Finance, Nasdaq, and several other newspapers, periodicals, and magazines. He has been interviewed and been a featured guest on many radio shows and podcasts. Finally, he is the co-host of Tax Avoidance is Legal, which is a nationally broadcast weekly Internet radio show.