Is It Time to Switch Your Business to a C Corporation?

For the first time in more than a decade, the highest personal tax rate tops the corporate rate. The maximum tax rate on individuals is now 39.6% for joint filers with taxable income over $450,000 and single filers above $400,000, while the top rate on corporations remains unchanged for 2013 at 35%. S firm owners are wondering if this means it is time for them to switch to a regular corporation. But after examining the options, the tax rate differential usually isn’t a large enough factor to warrant being taxed as a regular corporation.

The key disadvantage to being a regular corporation (what tax pros call a C corporation) is that C corporations still bear the burden of double taxation. Their profits are hit with corporate tax and shareholders pay tax on dividends distributed to them. That can push the effective tax rate above 50% on dividends paid to owners. The profits are taxed to the corporation at as much as 35%. If the firm’s shareholders are in the 39.6% individual tax bracket, they will pay a 23.8% tax on the dividends, including the new 3.8% Medicare surtax. If a shareholder is in a lower tax bracket and pays just a 15% tax on dividends, the effective rate is 44.75%. S firm shareholders owe income tax on the firm’s profits at a marginal rate of up to 39.6%, plus 3.8% for owners who aren't active in the business and are subject to the Medicare surtax. So if dividend payouts are planned, S corporation status remains less taxing.

C corporations also face a tax disadvantage when they are sold. In most cases, buyers want to do the acquisition as a purchase of the firm’s assets, rather than buying the corporation’s stock. That gives them a higher income tax basis in the acquired assets, allowing for greater depreciation and amortization deductions. Asset sales by regular corporations draw two layers of taxation. The gains are taxed at the corporate level at ordinary income rates, not the favorable low rates for individuals, and then at up to 23.8% when the after-tax proceeds are distributed to shareholders. That compares unfavorably to the usual single level of taxation on asset sales by S firms, except for the 35% built-in-gains tax, which hits corporations that convert to S status and sell assets at a profit within five years after switching.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

However, S firm owners should note that there’s talk of lowering the top corporate rate to 25% as part of tax reform, although 28% is probably more likely. On its face, that would seem to significantly favor C corporations. But tax reform won’t be done in a vacuum. Individual rates will be cut, too. Otherwise, proprietors, partners and S firm owners would face a huge tax increase, as business breaks they use would be trimmed to pay for lower rates on corporations. There is no chance lawmakers are going to allow that result to happen. Thus, most S corporation owners will benefit from retaining their S company election.