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To convert or not to convert to a C corporation: A complex question

To convert or not to convert to a C corporation: A complex question

By Matt Johnson, Partner with Warner Norcross + Judd LLP

The Tax Cuts and Jobs Act (Act) implements many changes to the Internal Revenue Code, potentially impacting a large number of entities and individuals. One such change is lowering the federal income tax applicable to C corporation to a flat 21% rate.  Corporations are also no longer subject to the alternative minimum tax.  Under the revised Internal Revenue Code, it may seem desirable for a profitable business to elect to be taxed as a C corporation, but the decision is not so simple.  The decision to convert to a C corporation is fact specific and requires sophisticated analysis that considers expected dividends, prospects for sale of the business and other factors.

For example, a profitable business that wants to maximize its cash flow to re-invest in the business and not distribute money to the shareholders should consider C corporation status.  A profitable business with debt that wants to pay down that debt as fast as possible may also be a good candidate to convert to a C corporation under the revised Internal Revenue Code.

Before the decision to convert to a C corporation is made, there are a number of factors to consider.  A C corporation is still subject to a second level of tax when distributions are made to the owners.  The second level of tax is not incurred until distributions are made or the corporation sells its assets and liquidates the business.  The business owner will need to consider his or her planning and exit event in making the decision to convert the entity. 

The anti-abuse rules applicable to C corporations, such as the personal holding company and accumulated earnings tax rules, still apply.  These rules could affect the business’ ability to retain earnings and avoid or defer the second level of tax.  If you consider the effect of the second level of tax, then C corporation status may not be advantageous for the business.  

For many small businesses, the shareholders are also employees of the business and need to be paid reasonable compensation for their services (as opposed to only receiving distributions as an owner).  While this may be an alternative to dividends and incurring the second level tax, compensation payments reduce the benefit of the 21% tax rate by reducing corporate income, are subject to employment taxes as well as income taxes.  

If the business does not need all of the business income and wants to distribute some of the business income on a current basis, pass-through status (LLC (taxed as a proprietorship or partnership) or S corporation) may still be the best form of entity.  Pass-through status may still be the best option for owners of profitable businesses that qualify for the new 20% deduction for pass-through business income under the revised Internal Revenue Code.  There are complex rules regarding qualification for this deduction, and each situation requires careful analysis by a tax professional.   

In addition, the new legislation only changes the federal tax implications for the business.  Each business remains subject to various state tax law regimes.  In Michigan, adopting C corporation status means the corporation will be taxable under the Michigan corporate income tax, which will affect the analysis and benefit of the reduced federal rate.  

A taxpayer should consider that just as these changes were recently implemented, the changes could be reversed or further changed in the future.  Many of the changes in the recent Tax Act expire if such changes are not extended by further tax legislation.  In addition, there are limitations on how frequently an entity may convert from a C corporation to an S corporation.  Conversion from a C corporation to a limited liability company could result in significant taxable income to the corporation.  

The actual mechanical process of converting will depend on the current form and the current tax classification of the entity.  In Michigan, as in many states, you must file a certificate of conversion to convert a limited liability company or partnership into a corporation.  However, the important change is to change the tax status of the entity with the Internal Revenue Service.  This may be done in several ways.  You should consult your tax preparer and legal counsel to determine the appropriate method for conversion.  

The decision of whether or not to convert to a C corporation is a complex question that should be discussed and analyzed with the appropriate professional advisors.  It is important to understand the advantages and the disadvantages to the seemingly attractive lower rate on corporate income before converting.  
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