The Incentive to be Taxed as a C Corporation Under the New Tax Lawby
The C Corporation tax rate has been lowered to 21 percent. There is no Personal Service Corporation nonsense like there used to be.
The main question is: Why would the government incentivize C Corporations? The answer is quite simple. There was an exodus of C Corporations to other countries because the tax rate was so much less than the 35 percent being charged in the U.S. With those C Corporations moving overseas, jobs went with them. The U.S. had the highest corporate tax rate in the world, and the smart companies were leaving. That meant the U.S. government was getting nothing in taxes.
An unintended consequence of the C Corporation tax bracket being lowered to 21 percent is that a majority of my client base, which are S Corporations, will pay more in taxes by remaining as an S Corporation than they would by revoking the election and being taxed as a C Corporation.
There is something that you need to get out of your head, that we have been brainwashed to think since college. You don’t want to have your clients taxed as a C Corporation because of double taxation. However, about five years ago, I began working a lot with C Corporations, as I was using them in conjunction with S Corporations, and what I found was that if you set these up properly, double taxation never comes into play.
Before you stop reading and think that I need to be committed to an insane asylum, let me explain.
Most tax accountants work with S Corporations. If you are a more than 2 percent shareholder of an S Corporation, you can’t participate in fringe benefits. As a consequence, not many tax pros know that there are several tax-free fringes that can make what the business owner was paying out of their pocket a corporate expense.
For instance, health insurance. Health insurance is not deductible to an S Corporation, but it is to a C Corporation. You don’t have to spend a ton of money on it, because you are going to get a high deductible plan. Why? Health Reimbursement Accounts (HRA). There is no limitation to what you can put into an HRA every year. Further, if you don’t use the amount in the HRA, it simply rolls over to the next year.
Now, stay with me. How is this different than a Health Savings Account (HSA)? Our family used to spend a fortune on health insurance. In 2017, it was supposed to go up to $3,900 a month for a family of four. That translated into $46,800 a year. That sounds bad, but until this year, our insurance company was paying more for our prescriptions alone than we were paying in premiums. The insurance company hated us.
In the past, we could never have a group policy, because we have no full-time workers, except for my wife and me. However, I hired my oldest son and made him a full-time employee, so now we have a group. We have health, dental, and vision for $1,700 a month. To supplement the price of health care, we can put whatever we want into an HRA, whereas an HSA has limits.
So, let’s say that I put the amount of the deductible into my son’s HRA, and then $20,000 into our HRA. If we don’t use the amount in the HRA this year, it rolls over, and we can put the same into it. Why would I do that?
The biggest expense of retirees is health care. Most retirees will take money out of their 401(k) or IRA to supplement their Medicare benefits. The problem with that is the money taken out is taxable. If it is taken out of an HRA, it’s tax free. Not to mention that I can put the excess into securities, and they will grow tax free. So, I don’t have to take taxable money out of my retirement.
Another tax-free benefit is a company car. I can buy any car with my corporation, and in 2018 the limits for depreciation are much higher, not to mention repairs, gas, tolls, and everything else. Yes, I will use it personally, but anyone who is self-employed is never really off duty and my personal use would be considered a de minimus fringe benefit. Not to mention the car insurance.
Other things are gym memberships, $5,150 for higher education, $5,000 for dependent care, parking — the list goes on and on. With all of the tax-free fringe benefits, it would take the need for a dividend out of the mix. I then couple that with a safe-harbor 401(k), allowing all of the owners to put up to $54,000 into the plan per year, with the only requirement to open it to my employees, and contribute only 3 percent of their compensation per year.
Not to mention that I can have different classes of stock. Common and preferred, Class A and Class B, all containing different rights. Then the bottom line, I only pay 21 percent, versus the convoluted way pass-throughs are taxed. And if you reach a certain amount, the special deduction goes away, or is reduced.
At tax time, for the clients I think might benefit from this conversion, I am going to do a side-by-side comparison for them, and probably do a lot of S Corporation revocations.
Remember, charge for the comparison, the phone call, and revocation of the S Corp.
For this gift, we can thank the big businesses that went overseas. I believe the unintended consequence is that it helps most of our client bases.
Craig W. Smalley, EA is the CEO and Founder of CWSEAPA®, PLLC, located in Orlando, Florida, with clients all over the country in every industry. He has been admitted to practice before the IRS as an Enrolled Agent, and has a Master's Certificate in Taxation from UCLA. He has been in practice since 1994, specializing in individual, partnership...