Time to Switch Your C Corp to S Corp Status?

Posted by Kim Chen on August 20th, 2014

Thanks to current tax law, the federal income tax rates for individuals remain historically low for single taxpayers with taxable income below $400,000 ($450,000 for married couples filing jointly). That’s the good news. The bad news: The rates for C corporations remain at the same levels that have been in place for years.

So you may wonder if you should switch a family C corporation to S corporation status? Then, all the company’s taxable income would be passed through to you and the other shareholders and taxed at the reduced rates for individuals. You also wouldn’t have to worry about double taxation of corporate profits anymore.

It’s something to think about but there are several factors to consider.

To assess what, if anything, your family C corporation should do, let’s first review the federal income tax rate structure for C corporations. The first $100,000 of annual corporate income is taxed at much lower rates than those that apply to high-income individuals. Specifically, the average rate on the first $100,000 of C corporation income is only 22.25 percent. If that same $100,000 was earned by an S corporation and passed through to you and the other family-member shareholders, the tax hit would almost certainly be at higher rates — probably 28 percent or more. If your family C corporation’s annual taxable income is above $335,000, the company pays an average federal rate of 34 percent. That’s still below the 39.6 percent maximum rate for individuals. (See right-hand chart for the complete tax rate schedule.)

*Does not include personal service corporations, which are taxed at a flat rate of 35%
So converting from C to S status might result in your family corporation handing out more cash to you and the other shareholders just so you can pay your personal income tax bills. In contrast, continuing as a C corporation and paying lower taxes at corporate rates could allow the company to keep more after-tax cash over the years.

Another factor to consider: The maximum federal income tax rate on C corporation dividends is now 20 percent for single people with taxable income above $400,000 ($450,000 for married joint-filing couples). Upper-income individuals may also owe the new 3.8 percent Medicare surtax on dividend income. For other taxpayers, the tax rate on dividends remains 15 percent. So the double taxation of corporate earnings is not nearly as big a problem as it was back in the days when dividends were taxed at high ordinary income rates.

Finally, don’t forget the “built-in gains” tax. As a general rule, it is imposed at a 35 percent rate on appreciated assets that are converted to cash or sold by a former C corporation within 10 years after converting to S corporation status. Since the built-in gains tax applies to zero-basis receivables and low-basis inventories (as well as any other appreciated corporate assets), the tax cost of making the C-to-S switch is often prohibitive. There may also be negative state income tax consequences.
For these reasons — but especially for the built-in gains tax reason — the best option is often to leave an existing C corporation alone, despite the fact that shareholder tax rates might be lower. Consult with our Naples and Marco CPAs to reach the proper conclusion.
© 2014 Thomson Reuters/Tax & Accounting