There is no question that the most eye-catching aspect of the recently promulgated federal tax reform is the reduction of the new maximum corporate tax rate to 21 percent from the current 35 percent. The new tax legislation became effective January 1, 2018, which means that many small enterprises that have been operating as either limited liability companies or S-corporations are now considering whether to reorganize as C corporations to optimize their taxation. For instance, it is predicted that many technology startup enterprises are going to take advantage of this change in 2018.
As of the beginning of this year, most small enterprises were traditionally structured as pass-through entities (limited liability companies or S corporations), where profits were taxed according to their owners’ personal tax rates. While there is some tax relief in the new legislation for some of those pass-through companies, including a temporary ability to deduct up to 20 percent of income, many enterprises could access the permanent cut by converting to full-blown C corporations. Notably, however, under the new tax code, enterprises involved in “professional services”, such as legal counsel, financial consulting or freelance design work, do not seem to qualify for this 20 percent pass-through deduction.
We strongly recommend all business owners to consult their accountants and attorneys before converting or taking any tangible steps towards changing your existing legal entity structure. Every entrepreneur and business owner must weigh benefits to their particular business and evaluate potential savings and weigh the desirability of conversion. It is important to remember that C corporations are double taxed–once on the 21 percent preferential rate, and again if and when the owners pay dividends to themselves. This means that as a result of more detailed analysis, it is quite possible that the two levels of tax will make a corporate operation far less advantageous than a partnership for many small entrepreneurs. However, if owners of the company do not intend to pay out dividends and are rather planning to re-invest a majority of profits back into the business as part of a long-term strategy, then it is likely that conversion is a viable option.
If, based on the analysis of accountants and tax professionals, a small business makes a decision to convert into a C corporation, such decision should not be taken lightly. While the immediate process of converting may take less than a week, provided your company is based in a state that allows for “statutory,” or streamlined, conversions, those companies that are formed in New York will need to take several extra legal steps, which are likely to include filing of a set of articles of incorporation with the secretary of state’s office, drafting a series of corporate bylaws, shareholder agreements and election of corporate officers and directors. The newly minted C corporation would also require owners to hold annual board meetings and issue stock certificates. Legal advisors need to be consulted with regard to legal effects of conversion on the existing company obligations, contracts and agreements with landlords, customers and vendors.