Navigating the Puzzle – C Corporation vs. S Corporation Considerations for Financial Institutions
With large-scale tax legislation changes looming, the choice of entity type between C corporation and S corporation is once again at the forefront of discussions for financial institutions. After a large decrease in corporate tax rates from the 2017 Tax Cuts and Jobs Act, this decision may have seemed more clear-cut for some banks. However, with new legislative changes on the horizon, there are more puzzle pieces in play and things to consider in making the decision.
Potential Legislative Changes
President Biden proposed significant tax reform through the American Jobs Plan and American Families Plan. The administration also recently released the “Green Book,” which provides detailed descriptions for widespread proposed changes in tax law. Some of the proposals relevant to the entity-type decision for financial institutions include:
- Increase the corporate tax rate from 21 percent to 28 percent for tax years beginning after December 31, 2021
- Increase the top individual tax bracket from 37 percent to 39.6 percent for tax years beginning after December 31, 2021
- Increase the long-term capital gain and qualified dividend tax rates to 39.6 percent for those with taxable income above $1 million, currently proposed to be retroactive to April 28, 2021
- Subject materially participating S corp shareholders with adjusted gross income of more than $400,000 to an additional 3.8 percent Medicare tax on their share of the flow-through business income
- Eliminate the basis step-up to fair market value on appreciated property at death; currently, there is a $1 million ($2 million per married couple) exclusion proposed
When evaluating the decision to be a C corp or S corp, there is no one-size-fits-all decision. There are many factors to consider in how the changes might affect the organization and shareholder group, and the new proposed legislation layers on additional complexity. The following are some items to consider:
Individual Income Tax
If there is an increase in the top individual tax brackets—from 37 percent to 39.6 percent—S corp shareholders will be subject to increased marginal tax on all income, including their flow-through income. In addition, shareholders who materially participate in the S corp are currently able to avoid the 3.8 percent net investment income tax (NIIT), while shareholders who do not materially participate are subject to the 3.8 percent NIIT. Under the proposed provisions, all shareholders will be subject to this 3.8 percent tax, either through the NIIT or self-employment tax, regardless of material participation.
Although not detailed in the Green Book, there have been proposals regarding implementing limitations on the 20 percent qualified business income deduction for S corp shareholders. This is a beneficial provision to the shareholders, but the benefits could be reduced or eliminated.
Tax planning will be important to help manage the shareholders’ resulting taxable income levels and applicability of the new tax rate increases.
Raising the corporate tax rate from 21 percent to 28 percent has been somewhat of a nonstarter for Republican lawmakers. At this point, given the political gridlock, this change seems unlikely. Other recent proposals have shown the increased rate being dropped to 25 percent or even remaining at 21 percent. However, President Biden has not yet abandoned efforts related to this tax rate increase.
As a result, other changes have entered the discussion, including the implementation of a 15 percent minimum tax on U.S. corporations’ book income. This measure has largely been limited so far to larger corporations with more than $2 billion in income.
Another consideration is regarding the state tax deduction. A C corp is allowed a deduction for state taxes in the calculation of federal taxable income. The state income tax attributable to S corp income is taxed at the individual level due to the pass-through nature of S corps. The S corp shareholders are limited to a state and local tax (SALT) deduction of $10,000 if they itemize their deductions on their individual returns, but this amount is often already maximized with withholding and/or real estate taxes. As a result, many S corp shareholders are often not able to realize any federal tax savings from the state tax paid on S corp income.
In response to this limitation, many states have implemented, or are considering implementing, an entity-level tax. The intent of the entity-level tax is to give the shareholders a workaround to circumvent the SALT deduction cap by providing a credit on the individual’s state income tax return in his or her state of residence.
As you can see, changing one piece of the puzzle of proposed legislation can significantly affect the decision regarding entity choice. Tax planning is critical throughout this process, and BKD is here to help. For more information, reach out to your BKD Trusted Advisor™ or submit the Contact Us form below.