Pass-through entities, such as S corporations and LLCs, have been all the rage for small business owners for the past few decades. Pass-through entities offer all of the liability benefits of traditional C corporations but without that pesky corporate level tax. Now that the maximum corporate tax rate just plunged from 35% to 21% under the new tax law, might people start looking at C corporations in a new, more favorable light? Might people start forming C corporations or even converting their S corporations and LLCs to C corporations?
But wait, didn’t the law also provide significant tax relief to pass-through entities in the form of a 20% tax deduction? Well, yes, but with some catches. One catch is that, unlike the corporate tax rate cut, the pass-through tax deduction is set to expire in 2025. Perhaps it will be extended, but there’s no way to know for sure. (Then again, a future Congress could raise the corporate tax rate back to 35%.)
Another catch is that there are significant limitations for certain services providers, such as doctors, lawyers, accountants, and engineers. If you are one of the specifically excluded professions and operate as a pass-through entity (e.g. an engineer providing services through a firm structured as an LLC), the 20% deduction begins to phase out after $157,000 in income for single taxpayers, $314,000 for married taxpayers. This could lead some people to consider splitting their businesses into two entities if, for example, one aspect of their business is offering engineering services (subject to the income exclusions) and another aspect of their business is offering architectural services (not subject to the income exclusions). They could end up with a C corporation for their engineering services and an LLC or S corporation for their architectural services.
However, before forming or converting your pass-through entity to a C corporation or splitting your business into two separate entities, keep in mind that there is still a corporate level tax, albeit a much lower one. Whether it’s 35% or 21%, if you are paying yourself all or most of your company’s profits, you will still probably want to avoid that corporate-level taxation. However, if your entity retains a significant portion of profits in order to grow the business, then a C corporation may make sense, especially if you fall under one of the professions subject to the pass-through exemption income restrictions.
The bottom line is that you should consult with your accountant to crunch the numbers and your lawyer to discuss the process. Which brings up another downside to converting – the fees you will have to pay professionals, along with any filings fees charged by your company’s state. Those costs need to be factored in. If the tax savings will be minimal, it may not be worth the costs of conversion. However, if you will be enjoying significant tax savings, it may be well worth the costs now to enjoy tax savings over the long haul.