How changes in corporate tax rate can affect choice of C vs. S corp.

• Author: Zambrano, Jose M.

In February 2012, President Barack Obama introduced The President's Framework for Business Tax Reform (available at tinyurl.com/7vceyo3), which proposes many changes in the tax law, including a reduction in the top corporate tax rate from 35% to 28%. This item examines the effect of the proposed lower corporate tax rates in an analysis of the tax results of converting an S corporation to a C corporation. According to IRS statistics, 1.78 million C corporation returns and more than 4 million S corporation returns were filed for tax year 2008. It is presumed that lowering C corporation tax rates by seven percentage points (from 35% to 28%) would prompt many small businesses to consider changing their tax status.

As the law stands, a large number of businesses in the United States have chosen to organize in the form of flowthrough entities such as S corporations, partnerships (either general or limited), and limited liability companies. In general, flowthrough structures result in profits being taxed at lower individual rates and, potentially, lower taxes due upon sale of the business. As a result, taxpayers generally pay lower taxes and avoid the trap of double taxation.

Many small business owners have viewed C corporations as an entity of last choice because they have some noticeable disadvantages. At the top of the list is the potential for double taxation because profits are taxed at the entity level and at the individual level when distributions are made in the form of dividends. Also, unlike their flowthrough counterparts, C corporations do not separately state income or loss items. These are combined to arrive at total taxable income, with the same tax rates applying to ordinary income and capital gains. Since income does not retain its original character in a corporation, many of the benefits available at the individual level are lost when the corporate form is chosen.

Example: A, a single individual, owns 100% of an S corporation's issued stock. For many years this company has been profitable, and the business has discretionary cash flow available for distribution to the owner. A has been paying taxes at individual tax rates. As his individual marginal tax rate becomes higher than the corporate tax rate, this owner may be motivated to convert to C status. Assume that in the first year of operation after restructuring to a C corporation, total taxable income is $2 million, and there are no distributions. Also assume that Congress has...