To “C” or Not to “C”, That is the Question

Should Your Business Restructure as a C-Corporation In Light of the New Tax Law

The Tax Cuts and Jobs Act (TCJA), which became effective January 1, 2018, was purportedly enacted to provide tax relief to businesses and thereby stimulate economic growth. Small businesses are the life blood of the United States’ economy, accounting for ninety-nine percent of all businesses, and half of the country’s jobs and gross domestic product. However, most small businesses do not qualify for the most significant financial relief afforded under the Act—i.e., the new maximum corporate tax rate of 21 percent versus the previous 35 percent rate—because approximately seventy-five percent of small businesses are structured as pass-through entities such as limited liability companies or S corporations whose profits are taxed according to the owner’s personal rate, which can range from 10 to 37 percent under the new tax law. In addition, the new maximum corporate tax rate of 21 percent is written as permanent while the personal tax rates are temporary and will expire at the end of 2025. As a result, we have received numerous inquiries from small business owners considering whether to reorganize their businesses as C corporations in order to take advantage of the lower, “permanent” corporate tax rate.

The most common forms of business enterprises used by small businesses in the United States are the sole proprietorship, partnership, and S corporation and are taxed as pass-through entities. Some small businesses operate as a limited liability company (LLC), which is a business structure allowed by state statute. LLCs with a single member or two or more members are taxed as a sole proprietorship or partnership, respectively, unless the LLC files Form 8832 and affirmatively elects to be treated as a corporation for federal income tax purposes. The mechanics of converting an S corporation, partnership, and sole proprietorship to a C corporation are set forth below and can be accomplished relatively quickly.

Restructuring From an S Corporation, Including an LLC Taxed as an S Corporation

An S-corporation can voluntarily revoke its S election and convert to a C corporation at any time. However, to be effective on the first day of the corporation’s current tax year, the corporation must revoke its S election by the fifteenth day of the third month of that tax year. A revocation filed after the fifteenth day of the third month of the tax year will take effect at the start of the corporation’s next taxable year. For example, if an S corporation’s tax year starts on January 1st of each year, in order to convert to a C corporation for 2018, the corporation must notify the Internal Revenue Service (IRS) by March 15, 2018 (the fifteenth day of the third month of its tax year). Otherwise, the C corporation status will not take effect until January 1, 2019.

Restructuring From a Partnership or LLC Taxed as a Sole Proprietorship or Partnership

The Texas Business Organizations Code (BOC) provides for a relatively simple procedure that allows a business owner to convert her business from a Texas partnership or LLC to a Texas corporation largely by filing a few short forms with the Secretary of State. This “statutory conversion” will automatically convert your partnership or LLC to a corporation and automatically transfer the partnership or LLC’s assets and liabilities to that new corporation. Because only one business entity is involved in a statutory conversion, it is not necessary to separately form a corporation prior to the conversion of the partnership or LLC, and once the steps necessary for the statutory conversion are completed, there is no need for a separate process to dissolve the partnership or LLC.

To convert a Texas partnership or LLC to a Texas corporation under the BOC, a business owner must:

  • Prepare a “plan of conversion”;
  • Obtain approval of the plan of conversion by the ownership or membership interests of the partnership or LLC;
  • File a “certificate of conversion” along with a “certificate of account status” with the Secretary of State;
  • File a “certificate of formation” with the Secretary of State; and
  • Adopt a “plan of conversion” and either file it with the Secretary of State, or, alternatively, certify that the plan will be available at the company’s principal place of business.

Sections 10.101 through 10.109 of the BOC are the statutory provisions primarily governing a statutory conversion, including setting forth the specific requirement of a plan of conversion.

Restructuring From a Sole Proprietorship

There are no provisions in the BOC governing sole proprietorships. While the BOC does provide for statutory conversion of “non-code organizations” to a domestic entity, a sole proprietorship is not included within the definition of an “organization” under the BOC. Therefore, to covert a sole proprietorship to a C corporation, the business owner must create a corporation by taking the following steps:

  • Choose a corporate name that includes the word or abbreviation “Incorporated,” “Corporation,” “Company,” “Limited,” “Corp.,” “Inc.,” “Co.,” or “Ltd.” and is distinguishable from the names of other business entities already on file with the Secretary of State (proposed names may be checked for availability on the Secretary of State’s SOSDirect website);
  • Prepare and file a “certificate of formation”;
  • Appoint a registered agent;
  • Set up a corporate records book;
  • Prepare corporate bylaws;
  • Appoint initial corporate directors;
  • Hold the first board of directors meeting to appoint corporate officers, adopt bylaws, select a corporate bank, authorize issuance of shares of stock, set the corporation’s fiscal year, and adopt an official stock certificate form and corporate seal, and record these actions in the corporate minutes;
  • Issue stock; and
  • Obtain a federal employer identification number from the IRS.[i]

But, Should You Convert?

The conversion process can be accomplished by most sole proprietorships, partnerships, LLCs, and S corporations in a matter of days.  However, the question of whether it makes sense to convert to a C corporation is a complex one that requires careful analysis.  To the extent projected taxable income can be accurately estimated, business owners should calculate the business’s tax liability under the different structures to determine which would work best.  In running the numbers, some key considerations are how you make your money and how much you make, and how much you pay in wages and own in tangible personal property.

The TCJA provides tax relief for pass-through entities and sole proprietorships, including a temporary ability to deduct up to 20 percent of “qualified business income” (QBI) subject to certain limits and restrictions. Generally, QBI is net income from each business activity of the business without counting amounts in the nature of compensation and excluding investment income.  However, the deduction may be reduced or even eliminated for “specified service businesses” or based on “wage and capital” limits.

How You Make Your Money and How Much You Make. Under the TCJA, “specified service businesses” may not qualify for the pass-through deduction or the deduction may be limited. These businesses include virtually every business that provides a personal service (e.g., health, law, accounting, insurance, performing arts, consulting, athletics and financial services) except engineering and architecture.

If your anticipated taxable income (from all sources, not just the business) is less than the amount of $157,500.00 (or $315,000.00 if married, filing jointly), the pass-through deduction will generally apply so that there is likely little need to restructure your business.

If your anticipated taxable income is greater than the threshold amount of $157,500.00 (or $315,000.00 if married, filing jointly), the deduction is reduced pro rata. Specifically, if your anticipated taxable income is greater than the threshold amount but less than $207,500.00 (or $415,000.00 if married, filing jointly), the deduction will be gradually reduced. If your anticipated taxable income is greater than $207,500.00 (or $415,000.00 if married, filing jointly), you will need to satisfy other tests to determine if you qualify for the deduction.

Therefore, if you operate a specified service business and your anticipated taxable income disqualifies you for the deduction, restructuring as a C corporation may make sense particularly if certain workarounds are available to your business to avoid double taxation[i] that C corporations may be subject to.

How Much You Pay in Wages/Own In Tangible Property. The deduction is also limited to the greater of (1) 50 percent of W-2 wages for your business or (2) the sum of 25 percent of W-2 wages and 2.5 percent of the unadjusted basis of all qualified business property (i.e., depreciable property available for use in your business). Therefore, the businesses that will benefit most are those that either have a lot of employees and pay a lot of wages, or have purchased a lot of tangible, depreciable property (e.g., buildings, equipment). This limit is phased in pro rata according to the same taxable income thresholds for specified service businesses.

Consequently, if your anticipated taxable income is below the threshold amount, you qualify for the deduction. However, if your anticipated taxable income is above the threshold amount, the availability of the deduction may be limited or eliminated.

If all of this seems about a clear as mud to you, you are not alone. The TCJA is so complex that many tax professionals are uncertain as to its application.  In fact, the American Institute of Certified Public Accountants has sent an urgent request to the IRS, seeking immediate guidance on the deduction for pass-through entities under the TCJA.  Guidance from the IRS will be critical in helping taxpayers and tax professionals navigate the new law, including determining how best to restructure a taxpayer’s business, if at all. Pending this guidance, a rush to restructure may prove unwise.

Business owners should also be mindful that although the language of the TCJA makes the reduction in the maximum corporate tax rate permanent, that could change. If recent voter polling data turns out to be an accurate indicator, Democrats could take back the majority in Congress in the 2018 midterm elections, and make changes to the law. Should that happen, it would likely prove more complicated to convert back to the business’ prior structure at best and impossible for at least a period of time at worst. For example, under the Internal Revenue Code, a C corporation is denied the ability to convert back to S corporation status within the five years following the conversion from an S corporation to a C corporation.

[i]   It is important to keep in mind that C corporations may be subject to double taxation; that is, once on the 21 percent preferential rate, and again if and when dividends are paid. If profits are kept and reinvested in the business as opposed to paying dividends (which is not the case for most businesses), converting to a C corporation may make sense.

[i]   Some or all of the following steps may also be necessary for a corporation created by a sole proprietor or an entity statutorily converted into a corporation with a new name:

  • Draft sales documents to transfer ownership of the assets—e.g., equipment, real property, vehicles, etc.—from the sole proprietorship to the new corporation.
  • Draft purchase documents to transfer shares of the new corporation to the owner of the sole proprietorship to pay for the assets being transferred.
  • Transfer employees from the sole proprietorship to the new corporation by terminating each employee of the sole proprietorship and hiring each one for the new corporation.
  • Open a new bank account in the name of the new corporation and transfer all monies from all bank accounts owned by the sole proprietorship.
  • Notify any state and county business licensing or taxing authorities of the change.
  • Cancel the policies owned by the sole proprietorship and purchase compatible policies for the new corporation.
  • Transfer all the titles to vehicles and real property into the name of the new corporation.
  • Notify all vendors and clients of the incorporation and reach an agreement regarding the amendment or assignment of any existing contracts to reflect the new corporation.

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