Many small s corporation clients have heard about the big breaks awarded to traditional c corporations and are asking if they should revoke their s corporation elections. We still think s corporations are a better deal for most small business owners. Here’s a simple explanation as to why.
Disclaimer: Since the tax code is complex, and the best answer depends on many factors, please consult with a tax professional or tax attorney for the best way to manage your small business taxation, liability, and finances. This advice is meant only as a basic introduction to entity and taxation management and it should not replace professional tax advice. Incorrectly managing your business taxes can lead to paying more tax, financial problems, liability problems, penalties, and even criminal charges.
It’s probably best to remain an s corporation and not switch to a c corporation
Typically, c corporations are double taxed, while with s corporations the net profit flows through to the personal tax level and gets taxed there – and after a new deduction, for some.
In our opinion, while the c corporation tax rates were dropped, it still most often does not make sense to expose yourself to double tax.
C Corporation taxation and the new tax bill
When a c corp turns a profit, they used to be taxed at anywhere from 15% to 39%.
Under the new tax law, however, the rate across the board is 21% – a huge tax cut.
The problem is, when a c corp makes money and is taxed – the taxes imposed on it’s shareholders for that income are not final. Dividends, from income that was already taxed at the corporate level, are typically taxed at 15 to 20% on a taxpayers personal return.
This is why, except for in very specific situations, tax practitioners do not recommend c corporations for most small businesses.
S Corporation taxation and the new tax bill – the QBI deduction
Income from s corporations, unlike c corps, are not taxed at all on the corporate level (with a few exceptions).
When an s corporation has a net profit the income passes through to the shareholders’ personal tax return (for most small business s corps) and is subject to the ordinary tax rate of the shareholder.
Under the new tax laws, these shareholders often get an additional exemption to where some of this income (often 20% of it) is not taxed at all.
An example of why it’s probably not best to switch
Joe’s Pool Cleaning Services Inc “nets” about $120,00 after expenses. Joe is the sole shareholder and he actively manages the business, his employees, sales, bookkeeping, and he even cleans some of the pools. He’s a busy, hands on business owner.
As a c corp, Joe would have to pay himself a reasonable salary for the work he does for the corporation. Let’s say he pays himself $72,000 on payroll, and takes the remaining net profit as a dividend.
Joe will pays 24% in income taxes on $72,000, and 15% in social security and medicare on $72,000 too. That’s $28,080.
Joe has $48,000 in net profit taxed at the corporate rate of 21%, which is $10,080.
Joe ass in individual taxpayer also must pay 15% on the $48,000 as dividends, which is $7200.
Joe and his c corporation will pay $45,360 in federal taxes under the new tax law.
Can Joe pay himself $120,000 in salary, pay the 15% social taxes, and avoid the 21% corporate tax altogether? Or, can Joe tax all of the corporate profit as a dividend and not pay himself a salary at all, therefore paying 21% (corporate tax) plus 15% (dividend tax) on the entire amount?
Not really. The rules of owner employee arrangements generally dictate that the salary of an active owner must be “reasonable”.
Taxed as an s corp, Joe’s taxes would be as follows:
Joe will pays 24% in income taxes on his $72,000 salary, and 15% in social security and medicare on the $72,000 as well. That’s $28,080.
Joe has $48,000 in remaining net profit that passes through to him as the shareholder. In many cases (but certainly not all – it’s complicated) the first $9600 of this income will be exempt from tax. So his tax on this income will be 24% (his ordinary income tax rate) on taxable pass through income of $38,400 for a total of $9216.
This is a total federal tax of $37,296, which is about 18% less than as a c corporation.
Even without the new QBI Exemption, Joe’s total tax would be $39,600. This is still much less than as in the c corporation example.
Remember, the rules are extremely complex and even if this example closely resembles your situation, there are many dynamic factors that could affect the best option.