BY JOE KRISTAN, CPA, Partner, Eide Bailly
Grandma’s pies were the best pies.
I know, everyone thinks their grandma made the best pies, but my Grandma’s were the best. If she were still baking, she could make a million bucks.
Should Grandma incorporate to save taxes?
The 21% top federal corporation tax rate that took effect last year can look mighty nice to a business owner who pays at a 37% top rate on her 1040. So why haven’t all businesses opted into the corporation income tax?
What Are the Choices?
Most businesses have a choice in how they are taxed. So-called “C corporations” are the ones that pay the corporation income tax. The other choice is to use a business form where the income is taxed on the owners’ personal 1040s. These include “S corporations,” most limited liability companies, and partnerships. These are called “pass-through” entities because the income of the business “passes through” without tax at the corporate level, and is instead taxed directly on owner forms 1040.
It’s Not Really Just 21%
It would be an easy choice if it were just 21% versus 37%. But for C corporation owners, 21% is just the first tax. If the owner wants to take the money out of the corporation, the income will be taxed again. If the earnings are distributed as a dividend, the owner will be paying federal rates as high as 23.8% on the dividend. If the owner gets the earnings by selling the corporation, the additional tax will hit in the year they receive the sales proceeds.
If Grandma Gertrude’s Pies makes $1 million in 2019 as a C corporation, it pays a $210,000 federal tax and has $790,000 left. If Grandma takes the after-tax income out as dividends, she pays another $188,020 on her 1040, increasing the combined tax to $398,020 – a 39.8% total tax. If Grandma lives in Iowa and sells all her pies here, that goes up to a combined $509,261 – about 50.92%. That’s more than 21%, by all accounts.
What about Pass-Throughs?
Most businesses taxed on individual tax returns are eligible for the “Qualified Business Income” deduction, or QBI. While the details of this are complex enough to dismay the stoutest old tax preparer, the bottom line is that only 80% of the 1040 business income is taxable when QBI applies. That means the real top federal tax rate on QBI is 29.6%, not 37%. More importantly, there is no second tax if Grandma Gertrude wants to take the after-tax money out of the business
What If Grandma Just Wants to Build the Company and Sell Out?
There is a special code provision that can let C corporation shareholders have their cake and eat it too, if they wait awhile. Owners of original-issue C corporation stock might qualify for the “Section 1202 exclusion” and pay zero capital gains on the sale of their stock. Not all businesses qualify – banks and restaurants don’t, for example. But manufacturers do, so if Grandma just holds on to her stock for five years and sells out in an IPO, the business could pay 21% as a C corporation until then and Grandma would get the sales proceeds, including the amount attributable to accumulated income, tax free.
Can Grandma Change Her Mind?
If Grandma starts her business in a format where it is taxed on her 1040, it is a simple manner to go to a C corporation. It’s much harder to go the other way, from a C corporation to a “pass-through” taxed on the 1040. An S corporation election is usually the best way to make that switch, but there are penalty taxes that can apply to former C corporations.
Perhaps Most Importantly, the Tax Law Changes.
The 21% corporate tax rate is the lowest it has been in living memory. But every Pizza Ranch in Iowa sees a would-be U.S. president campaigning for a corporation rate increase about twice a week. If one of them comes into office with a like-minded Congress, the 21% rate won’t last long. Given the difficulty of undoing the C corporation format, it’s something Grandma ought to consider.
Of Course, It’s More Complicated.
I plead guilty to oversimplifying. It’s a rare C corporation that distributes all income currently. Some never do. There are a lot of other things that come into play, including taxes in other states, Grandma’s salary, penalty taxes that can apply if C corporations hoard their income, and on and on. So take away these points:
- The 21% rate is great, but there’s a lot more to consider.
- It’s easy to become a C corporation, but it’s hard to undo one.
- Owners of startup C corporations might be able to avoid the second tax on C corporation income using Section 1202.
- Tax laws change. Consider not only what the rules are now, but also what they might be if control of the presidency and Congress changes.
| Joe Kristan