Tax Reform
The passing of the 2017 Tax Cuts and Jobs Act has many closely held business owners raising the question, “Should I convert to a C corporation?” On the surface, with the corporate tax rate now at a flat 21% and the highest individual tax rate at 37%, it would seem to be a “no brainer” that business owners would benefit by converting to corporations. However, additional factors should be considered before making such big decision. Such factors include:
- Does the business qualify for the pass-through deduction?
- Is the business generating research credits?
- Will the business pay dividends to its owners?
- What is the long-term exit strategy?
Looking at the first two factors, the pass-through deduction provides a 20% deduction on qualified business income. If business owners qualify for this deduction the tax rate on business income that flows to their personal return will be reduced from 37% to 29.6%.
For many profitable businesses who pay wages to the business owner(s), beginning in 2018, their tax liability will look similar to the example provided in Figure 1:
| Figure 1 | 12/31/2018 | |
| C-Corp | S-Corp | |
| Corporation Income | 500,000 | 500,000 |
| Wages | 250,000 | 250,000 |
| Total Income | 750,000 | |
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| Income Tax: | 21% | |
| Business Income | 105,000 | 148,000 |
| Wages | 92,500 | 92,500 |
| Total Tax Due | 197,500 | 240,500 |
When we consider the benefits of the reduced corporate tax rate, it appears that being a C-Corp is more favorable, even with the flow through deduction for partnerships and S-Corps. However, this doesn’t take into account companies that generate Research and Experimentation (R&E) tax credits.
Research and Experimentation Tax Credits
One common misconception about the 2017 tax law is that the R&E credit has gone away, which is not true. The R&E credit continues to be one of the best tools a taxpayer has to reduce their federal tax liability to a minimum tax rate, usually around 7.5%.
The basic premise of the R&E credit is that a business developing new or improved products, processes or techniques, can generate credits based on their qualifying research expenditures for that year. This includes wages, supply costs and contract research.
Figure 2 below, shows that when the R&E credit added to the above example, changing from a partnership or S-Corp to a C-Corp may not be the best solution.
| Figure 2 |
12/31/2018 | |
| C-Corp | S-Corp | |
| Corporation Income | 500,000 | 500,000 |
| Wages | 250,000 | 250,000 |
| = Total Income | 750,000 | |
|
|
||
| Income Tax: | ||
| Business Income (21%) | 105,000 | 148,000 |
| Wages | 92,500 | 92,500 |
| = Tax Liability before Credits | 197,500 | 240,500 |
| R&E Credits Generated | 150,000 | 150,000 |
| Maximum Credits Utilized | 67,500 | 150,000 |
| = Total Tax Due | 130,000 | 90,500 |
R&E as a Tax Savings Tool
Here we see that utilizing the R&E credit results in a significant reduction of tax liability for the S-Corp or partnership, which raises another common question: “How does a flow through entity utilize a dramatically larger credit compared to the C-Corp if the amount of credit generated is the same in both entities?” The answer lies in the way the tax law is written. R&E credits generated by a business can be used to offset any income generated from that same business activity.
C-Corp
For a C-Corp, income generated is generally limited to the income of that business, therefore, the wages paid to the owner(s) cannot be offset by the credit. Additionally, if the business incurs a net loss for the year, credits can still generate, but there is no income to offset with those generated credits.
S-Corp
For an S-Corp or partnership, the income generated does not only include the business income, but also any wages, guaranteed payments and interest paid to owners. Even if the business incurs a loss, if wages were paid to owners, owners can still offset wage income with credits generated during the year.
In the example outlined above, for a C-Corp only the income tax reported on the business tax return can be reduced to a 7.5% minimum tax rate, and the wages paid are taxed at the 37% individual tax rate. $500,000 × 7.5% = $37,500. $200,000 × 37% = $92,500. $37,500 + $92,500 = $130,000. For the S Corp, both the business income and the wages can be reduced to a 7.5% minimum tax rate if the business generated enough credits. In this example federal tax could be reduced to as low as $56,250 because only $150,000 of R&E credits were generated, and the federal tax liability was reduced to $90,500.
Utilizing the R&E credit is a powerful tool business owners have to offset their tax liability, even under the new tax law. Before making the decision to change to a corporation, it is important to consider and have a conversation about the R&E Credit.
If you think it may make sense to convert to a C corporation but also believe you may qualify for R&E credits, or may not have utilized the credit to its fullest extent in prior years, contact Clayton & McKervey Shareholders Sarah Russell or Tim Finerty for a free assessment to determine your potential R&E credit.
