Biden’s Proposals Prompt Rethinking the C vs. S Corp Conundrum

The Tax Cuts and Jobs Act’s reduction in the corporate rate from 35 percent to 21 percent prompted businesses to take a second look at which entity form to choose and whether, for example, they should convert from an S corporation taxed as a passthrough entity with a single level of tax to a C corporation subject to a “double tax” — a 21 percent flat tax rate on corporate earnings and a second tax of 23.8 percent at the shareholder level on distributions of earnings and profits. 

Under the TCJA, the effective tax rate for investors in passthrough entities can range from 33.4 percent to 40.8 percent, depending on whether their share of the business income qualifies for the 20 percent deduction under section 199A. That compares with C corporations’ 39.8 percent effective tax rate when considering the second level of tax. 

According to Brian T. Lovett of Withum Smith+Brown PC, “the double taxation of a corporation right now [is] relatively affordable.” 

However, President Biden’s proposals in his American Families Plan — an increase in the capital gains and qualified dividend rate to the maximum ordinary income rate for taxpayers with income over a specified threshold and an increase in the corporate rate to something north of 21 percent — will complicate the choice of entity analysis, Lovett said during an August 17 webcast sponsored by Strafford. 

Although tax rates will increase because the government can’t spend trillions of dollars and not raise taxes, “our planning should be focused on making wise business decisions rather than reacting out of fear and without full knowledge,” Brant advised. 

At the extreme, the flat corporate tax rate could ratchet up to 28 percent and the top individual tax rate rise from 37 percent to 39.6 percent under Biden’s proposals. If, along with those changes, “section 199A is unscathed, I think the road from subchapter C to subchapter S may get very busy,” Brant surmised. 

Conversely, despite silence on section 199A, if the provision “receives an untimely death, especially for corporations that need to retain earnings . . . traveling to subchapter C may still be attractive,” Brant suggested. 

A flat tax at 28 percent isn’t that bad compared with a top individual rate of 39.6 percent, Brant said. If there’s a compromise yielding a lower corporate tax rate, clients will be calling inquiring about “that trip to subchapter C,” he said. 

Brant, like other observers, suggested that the more likely scenario is the corporate tax rate landing between 21 and 25 percent.