When small business owners first heard about the new 21 percent tax rate for the C Corporation, many thought that switching to a C-Corp in 2018 would be a great way to save on federal taxes. This was especially true for those taxpayers with a high income and an effective individual tax rate above 21 percent. However, the devil is in the details, and with the new tax rules, switching to a C-Corp won’t help small businesses save on their tax bill.
The table below gives you a good look at how you would pay taxes on your profits, depending on your Form 1040 tax bracket. In the S corporation column, the tax rates are listed by the brackets that apply to individuals. To see exactly how this table works, let’s say that you are in the 34 percent tax bracket and have $100,000 in profits.
If you operate as an S corporation, the profits come to you on a K-1 and you pay your Form 1040 taxes at the 34 percent rate, for a total tax of $34,000 on your S corporation profits.
If you operate as a C corporation, the profits are first taxed at the C corporation level at a rate of 21 percent, for a tax of $21,000. This leaves you with $79,000 of the $100,000 in profits available for distribution as a dividend to you.
If you fully distribute the $79,000 as a dividend, you will be subject to a dividend tax of 15 percent. This creates a $11,850 tax ($79,000 x 15 percent). *This is sometimes referred to as “double taxation.”
Your tax bracket also triggers the net investment income tax (NIIT) that applies because of your dividend income. The NIIT is $3,002 ($79,000 x 3.8 percent).
As a C corporation, your total federal taxes on the $100,000 of income are $35,852, which consists of the following:
- C corporation taxes of $21,000 (21 percent)
- + 1040 dividend taxes of $11,850 (11.85 percent)
- + 1040 NIIT of $3,002 (3.002 percent)
Total = $35,852 (35.85 percent)
Based on the same $100,000 in profits, operating as an S corporation results in $34,000 to the government compared with the C corporation, where you and the corporation combined pay $35,853. The winner: the S corporation.
With this background in mind, look at the table below and compare column 1 (S Corp.) with column 2 (C Corp.) to see the percentage taxes on the profits. You will note that in all cases, the S corporation pays less in taxes.
Note: NIIT does not apply to S corporation profits if the shareholder materially participates in the S corporation.
So, based on the tax rates alone, you have no reason to switch to a C Corporation because of the recent tax reform.
S Corporations and other pass-through entities can further reduce their overall tax rate below those that are listed in the table above by taking advantage of the new “Qualified Business Income” or “QBI” deduction. This deduction allows pass-through businesses to deduct up to 20% of their net income, effectively making them taxed on only 80 cents of each dollar.
The QBI deduction is limited if the taxpayer’s taxable income exceeds certain thresholds. However, it’s fairly complicated and this subject will be a blog post for another day.