Should I Consider Changing My Business to a C Corporation?

With the recent legislative fiscal cliff activities behind us and higher income tax burdens now clearly defined for wealthier Americans, some business owners are challenging the foundation of the tax structure for their business operations.

The resulting question: Would I be better off changing to a C corporation?

Both Democrats and Republicans have offered proposals calling for a reduction to the top corporate tax rate, currently at 35 percent, to something in the range of 25 to 28 percent.  At first glance, this would appear to represent a very attractive alternative to the new top individual marginal rate of 39.6 percent.  That rate, combined with the new 3.8 percent Medicare tax that can apply to individuals who do not materially participate in a business in which they own an interest and other income-based limitations on personal exemptions and itemized deductions, can translate to an effective tax rate of roughly 45 percent.

For a business that is expanding and retaining its earnings to support capital requirements connected with growth, a lower C corporation tax rate would potentially have greater appeal, as higher after-tax earnings would result.

However, the knock against C corporations has traditionally involved the second incidence of tax that arises when dividends are paid or assets are sold and the company is liquidated.  Fiscal cliff tax legislation yielded a unified rate of 20 percent for both dividend income and long-term capital gains.  Both types of income are also subject to the new 3.8 Medicare tax and will trigger income-based limitations on personal exemptions and itemized deductions, yielding an effective tax rate of roughly 25 percent.  A combined corporate level tax in the 25 to 28 percent range and a second personal level of tax of roughly 25 percent would come in at roughly 43 percent, or slightly lower than the current 45 percent combined effective pass-through rate, a circumstance which has not been the case since fundamental tax rate changes were made in 1986.

Should corporate tax rates be lowered as part of future legislative activities, a process by itself wrought with significant obstacles involving larger political agendas, the regular corporation version S corporation/LLC or other pass-through entity form debate is sure to heat up.  Stay tuned!