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Terminating S Corp Election
By Jason Watson, CPA
Posted Tuesday, October 5, 2021
S Corps have relished being the class favorite for all kinds of reasons as stated in this book. However, the original C Corp could be making a comeback based on flawed logic from the Tax Cuts and Jobs Act of 2017.
The primary motivation is the seemingly attractive 21% tax rate for C corporations and while this might be lower than some taxpayer’s marginal rate, this is a sucker hole for business owners for two painfully obvious reasons. First, your marginal rate might be 22% or 24%, but your effective tax rate (or blended tax rate) is much lower. We’ll show you… not to worry.
Second, there is a little thing called double taxation where the C corporation pays a tax and then the shareholders pay a dividend tax on the money that is distributed. And… if you think you’re a smarty pants and say, “Yeah, but, I’ll just keep all my money in the C corporation for a rainy day and lower tax rates,” there is another little thing called accumulated earnings tax.
Buckle up buttercup ‘cause here we go-
|S Corp Income||100,000||200,000||300,000|
|Total Tax S Corp||13,100||36,390||62,626|
|C Corp Income||100,000||200,000||300,000|
|C Corp Tax||21,000||42,000||63,000|
|Total C Corp Tax||21,000||65,700||107,556|
|Effective S Tax Rate||13.1%||18.2%||20.9%|
|Effective C Tax Rate||21.0%||32.9%||35.9%|
|Delta (extra tax because of C Corp)||7.9%||14.7%||15.0%|
As you can see, a C Corp does not make sense after you add in capital gains tax on the dividends. Also note the effective tax rate (or labeled as tax “pain”) for the S corporation owner. At $100,000 in net business income, the total tax pain including payroll taxes is 13.1%, and at $200,000 it is only 18.2%. This is still well below the C corporation tax rate of 21%.
One more thing that is not computed above; C corporations do not get the Section 199A deduction which is 20%. 20% times the marginal tax bracket of 15% is another 3% savings; 20% times the marginal tax bracket of 37% is another 7% savings. So, please pump the brakes on the “I wanna dump my S Corp for the magical tax arbitrage offered by a C Corp” nonsense. Wow, that was harsh. We did tell you to buckle up but then we offended you by calling you buttercup. Safety with an insult.
Sidebar: In a previous chapter we highlighted several reasons why a C corporation makes sense. Paring down debt, employee stock plans, funding with a 401k, keep income off your individual tax return, among many ideas.
Let’s say there are other reason to revoke S Corp election. Yes, you can change back and the present-day solution is accomplished by either liquidating, or terminating the S Corp election.
Liquidation is the more complicated of the two. In a nutshell, the process begins with a unanimous vote to close the business. Once that decision is made, it’s a complicated process of contacting creditors, assessing receivables, distributing or selling property and closing up the books.
Termination, moderately more elegant. Terminating the S Corp election can happen one of two ways. Preferably by revocation, or the next best alternative, violating one of the S Corp rules. Violating one of the S corporation rules is not an elegant option however.
Therefore, revocation is the preferred direct route and is as simple as writing a statement to the IRS revoking your S Corp election. In this manner, obtaining written consent from more than 50% of your shareholders is required. Simple for one or two owner S Corps, but community property states, tenants in common, and majority shareholders could complicate that. Again, if the underlying entity is an LLC then the members will be bound by the Operating Agreement in terms of voting and other requirements.
When your S corporation election is revoked, either intentionally or not, your business will more than likely revert to a C Corp for taxation. We can then file a Form 8832 which will reclassify your business back to an LLC or partnership, again for taxation. Remember, the underlying entity does not change with the Secretary of State. There might be some accounting headache and subsequent tax consequences with capital accounts or other assets, but we can advise you on those concerns once all the details are vetted out.
Why would you want to revoke your S Corp election? There are many reasons- business closed or is shrinking to a point where it doesn’t make sense, lost the contract gig, got converted from 1099 to W-2, foreign investors, etc. are among the most frequent. We can help guide you as these situations arise.
Notice how making too much income wasn’t on the list of possible reasons. Of course there are exceptions, but generally speaking if you make $30,000 or $300,000 or even $3,000,000, the S Corp election is going to be your friend.
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