Should My Business Be An S-Corp or a C-Corp?
by Herbert K. Daroff, J.D., CFP, AEPMr. Daroff, a contributing editor to this magazine, is affiliated with Baystate Financial Planning, Wellesley, Ma. Visit www.baystatefinancialplanning.com
I think the answer to that question may be, “YES!” Consider having both. I think that the operating company should be an S-Corp, have the real estate owned outside of the business as an LLC, and find a legitimate business reason to also establish a C-Corp, with a fiscal year other than calendar year. Clearly, every case should be reviewed by your professional advisors for its individual facts. Prescription without diagnosis is malpractice.
But, consider the following example of a jewelry store:
The retail operations could be an S-Corp. The store, itself, could be owned in an LLC. The repair work could be a C-Corp. Why? There are a number of expenses that your CPA will not let you deduct, such as sports tickets, lunches, country club dues, and life insurance.
C-Corporations are now taxed at 21%. We used to have a problem if the C-Corp was a personal service corporation (PSC), which were taxed at a flat 35%. Now, all C-Corporations are taxed at a flat 21%. So, a $10,000 expense that would have needed $15,385.62 pre-tax in a 35% or $15,873.02 pre-tax in a top personal tax bracket of 37%, would now need only $12,658.23 in a 21% tax bracket (all numbers are federal income tax only, at the top tax rate, plus state tax, as applicable). That’s $2,726.39 to $3,214.79 less pre-tax money needed for a $10,000 expense.
However, the owners of the S-Corp may only pay income taxes on 80% of their Qualified Business Income (QBI, IRC Sec. 199A). The 20% deduction is subject to a series of limits based on W-2 wages and other factors. So, should my S-Corp become a C-Corp? Probably, “NO”
QBI is the net income with respect to your partnership, S corporation, or sole proprietorship trade or business conducted in the U.S. where taxes pass through to the owner’s tax returns. Investment related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.
But, first, is the pass-through business a “Specified Service Trade or Business” (IRC Sec. 199A(d)(2) and IRC Sec. 1202(e)(3)) such as, health, law, accounting, actuarial, performing arts, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners? If yes, then second, is the taxpayer’s taxable income less than $315,000 (married filing jointly) or $157,500 (for all others)? If yes, then the taxpayer can deduct 20% of his or her qualified business income. If the taxpayer’s income is greater than $415,000 (married filing jointly) or $207,500 (for all others), then all of the qualified business income is taxable. No deduction. Between $315,000 and $415,000 (married filing jointly and $157,500 and $207,500 (for all others), there is a partial deduction. But, wait. There’s more. Your deduction for QBI cannot exceed the greater of:
(1) 50% of your allocable share of the W-2 wages paid with respect to the qualified trade or business, or
(2) the sum of:
(a) 25% of such wages; plus
(b) 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate).
There are other benefits to taking W-2 and not just K-1. K-1 is not subject to FICA/FUTA (6.2% up to the Social Security wage base ($128,400 in 2018) plus 1.45% on all earned income). However, W-2 counts toward Social Security benefits, qualified plan contributions, and eligibility for disability insurance. And, now, W-2 is also important for maximizing your QBI deduction.
Other limitations may apply in certain circumstances. For example, taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships may also have a reduction in the amount they can deduct.
The combination of S-Corp and C-Corp may be beneficial. And, if the C-Corp has, for example, a June 30 fiscal year end (compared with the December 31 fiscal year end for the S-Corp), there may also be opportunities to shift income into a later point in time.
We await technical corrections and Treasury Regulations to sort out all of this. In the meantime, work with your full advisory team (attorney, accountant, financial planner, insurance agent, investment advisor, etc.) to begin planning for 2018. Remember, prescription without diagnosis is malpractice. ◊