May 22, 2018
By Kevin Harris
Since the enactment of The Tax Cuts and Jobs Act last year, companies across industry sectors – including manufacturing – have been reexamining the structure of their business entities to determine whether they can take advantage of the significant reduction in corporate tax rates.
With the drop in the corporate rate from 35 to 21 percent, it would seem to follow that S corporations would jump at the chance to become C corporations—especially when considering that pass-through owners will be taxed at a much higher rate. Individual income rates have also been temporarily reduced—another change to consider because the personal income tax return comes into play in business entity selection.
Does it make sense to change the structure of your manufacturing business from an S corp to a C corp? The answer: it depends. According to research conducted by Accounting Today, manufacturers, distributors and service companies could end up with a larger tax liability if they switch to a C corp status. And while Congress eliminated the 9 percent Domestic Production Activities Deduction (DPAD) for manufacturers, the new law offers a much broader deduction for S corps. Still, some manufacturers may achieve tax savings if they change their entity structure to a C corp.
It is useful to review the differences between C corps and S corps, and then review changes under tax reform.
The greatest differences between C corps and S corps comes down to ownership, shareholder rights and the big one—taxation. C corps are obviously subject to the corporate tax rate, but S corps allow for pass-through taxation so that your business’ profits and losses are taxed at the owner’s personal income tax rates.
Unless you take steps to become an S corp, most large businesses default to a C corp. In fact, the majority of U.S. businesses are C corps. Let’s take a closer look at C corps since they are in the spotlight.
C Corp Taxation
In a C corp, individual shareholders own the business and have limited liability protection. This protection generally protects them from business debts or liability. However, officers of the company, such as the CEO and COO, make the day-to-day decisions.
Note that C corps may be taxed twice, first at the corporate level and then at the owner’s personal income tax returns if the distribution of income is made to shareholders as dividends.
S Corp Taxation
Paying taxes as an S corp is different. Shareholders report their share of the business’ income and losses on their personal tax return. Income and losses are taxed only at the personal income tax level, so they aren’t subject to corporate tax. When you hear about pass-through income, it means part of the business’ income and losses pass through to their personal tax returns.
S corps with less than $157,500 in annual income (single filers) and $315,000 (married joint filers) can most benefit from the 20 percent deduction. After these levels, there are some limits depending on business income and the wages you pay your employees, among other factors.
Tax Reform Changes
The tax reform legislation made changes that took effect Jan. 1, 2018, but business owners won’t see the impact of the changes until filing their taxes in 2019. As we noted above, the corporate income tax rate for C corps has been cut to 21 percent. Additionally, C corps can deduct the cost of fringe benefits they provide to employees, such as health and disability insurance.
The second major change is that owners of S corps, as well as other pass-through entities (LLCs, partnerships and sole proprietorships), will be able to deduct 20 percent of qualified business income on their personal tax returns—until 2025. In other words, Congress built in this deduction for S corps to make up for the lower C corp tax rate.
Weighing the Decision
Each manufacturer should work closely with a tax advisor to determine which entity structure makes sense for them. It may be tempting for S corps to restructure as C corps, but it’s not that simple. While the 21 percent tax rate for C corps looks very attractive, there is still the issue of double taxation; if your business generates a certain level of revenue, you will have to pay personal taxes on the dividends. However, if your manufacturing business is still in a state of growth and you plan to reinvest profits back into the business, you may benefit from the C corp tax cut.
You will also need to consider whether you typically retain a fair amount of cash in your manufacturing operation for expansion or other reasons. Under a C corp, the IRS can consider accumulated cash excessive and rule that it be distributed as dividends, which could increase your taxes.
Another consideration is the length of time you plan to hold the company. Whether you’re in for the short or long term can determine the best entity choice for your business. Also, keep in mind that once you switch to become a C corp, you generally can’t revert to an S corp status for at least five years.
Goldin Peiser & Peiser can provide various scenarios based on your current and projected profits to determine the best entity structure for your business. For more information, please contact GPP or call Kevin Harris at 214-365-2473 or email him. Learn more about the Manufacturing and Distribution Services Group at Goldin Peiser & Peiser.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.