With the lowering of C corporation tax rates, several clients have asked about corporate structure. In the past, the best choice was almost always an S corporation. But the new tax law has made it a more difficult question to answer. There are a lot of factors that play into the decision.
Many farms were incorporated as C-corps in the 1960s, 1970s and 1980s. At the time, the highest corporate tax rate was lower than the individual rate, and C-corps allowed farmers to deduct personal expenses such as housing. However, there was a price to pay. Land contributed to a C-corp was trapped -- the corporation had to pay tax on profits, and the shareholders paid tax on the dividend distributions, or ultimately, liquidation gains (double taxation). However, until 1986, there was an opportunity for closely-held C-corp to liquidate without the double tax. That door closed over 30 years ago.
After the 1986 Tax Reform Act, individual tax rates went down. Many farmers looked at converting to an S-corp to avoid the double taxation, especially at retirement. This was especially the case if the stockholders were no longer living on the farm. Pass-through income-tax treatment and reduction of self-employment tax were a big draw to farmers. But with the 2018 tax law changes, people have begun to ask if C-corps could be making a comeback.
Starting in 2018, the tax rate for a C-corp is a flat 21%, and the highest individual rate is 37%. In addition, dividends from a corporation are taxed at 0%, 15% or 20% (depending upon the stockholder's level of taxable income), and they are subject to the net investment income tax. Almost always, the tax rate paid by S-corp shareholders will be less than the combined tax rate on a C-corp paying dividends.
The S-corp has another tax benefit under the new law. The Section 199A deduction for qualified business income only applies to pass-through entities, not C-corps. The deduction is subject to limitations, however. This effectively puts the top tax rate on qualified business income earned by an S-corp as low as 29.6%.
For more on the Section 199A deduction, see last month's Taxlink column here: https://www.dtnpf.com/…
However, if you want to convert a C-corp into an S-corp, there is a hidden wrinkle called the built-in gains (BIG) tax. For a period of five years after the S election is made, the shareholders recognize additional tax on the gain that was on the books as of the date of the switch. The BIG tax can be mitigated with proper planning.
Another issue with changing to an S-corp is the loss of certain tax attributes. If the C-corp had a net operating loss, it can only be used to offset the BIG tax after the switch. Any excess would be suspended until the S-corp converted back to a C-corp. S-corp shareholders may not be able to utilize prior-year losses generated by the corporation when it was a C-corp.
There are other considerations when looking at a conversion to an S-corp. For example, S-corp losses can be used to offset other personal income (subject to some limitations), whereas C-corp losses can only offset future C-corp profits. Also, Schedule K-1 income from an S-corp is not subject to self-employment tax.
So what is the best entity choice? For the majority of my farm clients, it is S-corp. The exception is the smaller farm corporation that provides tax-free housing to its shareholder-employees.
Editor's Note: Tax Columnist Rod Mauszycki is a CPA and tax partner with the accounting firm of CliftonLarsonAllen, in Minneapolis, Minnesota.
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