Due to changes under the Tax Cuts and Jobs Act (TCJA), you might be wondering what the optimal structure for your business is now. Changes in federal tax rates have many businesses considering making a switch to C corporation status. Is this a good idea? What does a change like this entail? Learn more.

Some important changes under the TCJA

• For tax years beginning in 2018 and beyond, the federal income tax rate on C corporations is now a flat 21% (previously C corps were subject to graduated rates ranging from 15% to 35%)
• The maximum federal income tax rate for an individual taxpayer’s income from sole proprietorships and pass through entities (including partnerships, limited liability companies and S corporations) has been reduced to 37%.
• Beginning in 2026, the individual federal income tax rates are scheduled to return to pre-TCJA levels (maxed out at 39.6%)

The lower rate for C corporations has many sole proprietorships and pass through entities considering switching to C corp status….but don’t be too hasty! There are considerations you should factor in before making the switch.

Tax considerations you should make before switching to C corp status

Double taxation

• A C corporation’s income can potentially be taxed twice- once at the corporate level and once at the shareholder level when corporate profits are paid out as taxable dividends.
• Dividends received by individual shareholders and trusts and estates are taxed at a maximum federal rate of 20% under current law. Additionally, dividends can be hit with the 3.8% net investment income tax (NIIT)
• Double taxation can also arise if you sell your C corp shares for profit.
• The threat of double taxation typically makes it a bad idea to use a C corp to own appreciating assets, like patents and real estate.

To avoid double taxation, some corporations keep all corporate profits and gains inside the corporation. The drawback here is that your corporation runs the risk of being hit with the accumulated earnings tax (AET). This is a corporate level tax assessed by the IRS when…

1. A C corp’s accumulated earnings exceed $250,000 ($150,000 for a personal service corporation), and
2. The corporation cannot demonstrate economic need for the excess accumulated earnings.

PHC Tax

To prevent C corporations from avoiding double taxation by keeping all profits and gains inside the business, there is another corporate tax called the personal holding company (PHC) tax. PHC status is determined annually, so a corporation can unknowingly be assessed with the PHC tax even if it hasn’t been considered a PHC in prior years.

PHCs meet these two tests:

1. Income test- At least 60% of the corporation’s adjusted ordinary gross income (AOGI) must consist of PHC income. PHC income is the portion of AGI comprised of dividends, interest income, royalties, annuities, rental income, taxable distributions from estates and trusts and income from personal service contracts.
2. Ownership test- At any time during the last half of the tax year, more than 50% of the value of the corporation’s outstanding stock is owned, directly or indirectly by (or for) five or fewer individuals.

To avoid the PHC tax, you have to fail one of these two tests (or both). The personal holding company tax is 20% times the undistributed passive income. You can also avoid this PHC tax by paying a dividend to the shareholders in the amount of the passive income.

So, in a nutshell, operating as a C corporation to take advantage of the new 21% corporate federal income tax rate may not be as fruitful as you hoped it would be but may be the right choice depending on the facts and circumstances.

The best business structure depends on your circumstances—we can help you find the best answer for your specific situation. Contact us.

The TCJA…So Many Changes, So Many Questions…we can help you navigate this huge tax overhaul! Need help with your tax planning? Contact any member of our Tax Services Team.