The Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017, and we have had a full tax year, and the following tax season, to absorb the impact of the myriad of tax law changes that were the result. In response to this, many construction companies have asked if they should consider revoking their S-Corporation election due to the attractive flat 21% income tax rate afforded to C-Corporations and the repeal of corporate-level Alternative Minimum Tax.
The answer to their question is simple: Yes, you should consider the revocation.
The decision process, however, is far from simple.
Let’s not forget, if the decision is made to revoke, you may not re-elect S-Corporation status for another five years!
What are some of the factors to be considered?
Does the company have a history of paying out substantially all profits to its owners?
- If the company has a history of (and intends to continue) distributing substantially all profits to its shareholders, the double taxation of the C-Corporation is still a hurdle that the S-Corporation successfully avoids even though the C-Corporation pays a flat 21% federal income tax.
- Under the TCJA, S-Corporation shareholders are potentially eligible for a deduction of up to 20% of the allocated ordinary income. The effective tax rate on the shareholders’ distributive share of profits would need to be analyzed to determine the overall tax burden when compared to the flat 21% corporate tax rate, in addition to the tax to be paid on dividends at the individual level.
Has the company “outgrown” its S-Corporation structure? This is an issue that goes beyond the income tax burden.
- Does the company have an increased need for capital? if so, how is the company going to meet these additional capital needs?
- Is the company seeking investment capital that would invalidate the S-election, such as an excess of 100 shareholders or ineligible shareholders (non-U.S. citizen or resident alien, LLC investors or Corporations)?
- Is the company going to retain profits in order to meet these capital needs?
Corporations that have significant capital needs due to expansion may find that leaving profits in the company at a reduced rate of 21% is more efficient than recognizing those profits at the individual level and funding tax distributions to the shareholders to meet these tax obligations.
The answers to the above questions, among others, will guide the discussion as to whether or not the S-Corporation tax structure is the proper fit for your construction company.
In the end, the structure of the company should be aligned with the overall goals of the company.
If you would like to discuss your company’s tax structure or have questions, please contact your local Blue & Co. advisor.