Have you heard that your entity election has a 21 percent tax rate for C Corporations? This certainly makes C Corporations an attractive option if you’ve been paying nearly 40 percent in the past.
This is the case when you find yourself as an “out-of-favor” group for the 20% 199A deduction. Take a look at the table below. It exhibits the tax rates you’d pay on your profits, based off your personal tax bracket. In the S corporation column, we use the personal tax brackets since it’s a flow through entity.
Assume you’re in the 34% tax bracket, and you 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% rate. This means you have a total tax on your S corporation profits of $34,000.
If you operate as a C corporation, the profits are first taxed at the C corporation level at a rate of 21%, 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.
Pretty sweet, right?
Now, let’s say you pay taxes for a second time on the dividend you receive from the corporation at 15%. This creates an $11,850 tax ($79,000 x 15 percent).
Your tax bracket also triggers the net investment income tax (NIIT) on 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
- 1040 dividend taxes of $11,850
- 1040 NIIT of $3,002
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, which pays $35,853.
Who is the winner? The S corporation.
You might be asking yourself: “Why no NIIT on the S corporation profits?” Well, If the shareholder materially participates in the S corporation, the NIIT does not apply to the pass-through income derived from active business operations.
In the table below, we treat you as materially participating in your S corporation.
Okay, with this background, you can see how the table below works. You simply compare column 1 (S Corp.) with column 2 (C Corp.) to see the percentage taxes on the profits. And you will note in all cases, the S corporation pays less in taxes.
So based on the tax rates alone, you have no reason to switch to the C corporation because of tax reform. However, we will share how having both a C Corporation and S Corporation working together can actually give you the best of both worlds.