The “amazing loophole.” Time to convert your your LLC or S Corp into a C Corporation?

During my career, I have represented hundreds of small businesses during their formation and start-up phases. For the vast majority of these clients, I recommended an LLC due to the LLC’s ease of legal maintenance and structural practicalities. Very infrequently would I recommend a C Corporation-type. That may change now; the proposed tax consequences may shift the balance in favor of the C Corp. And this also raises the question whether existing LLCs and S-Corps should convert into a C Corp. Per Inc. magazine

“There are many positive aspects to this tax law for small businesses,” Reitmeyer says. But the most eye-catching, in terms of financial relief? The new maximum corporate tax rate of just 21 percent, a substantial drop from the current 35 percent. . .

Here’s why: Most U.S. small businesses currently don’t qualify for the reduced corporate tax rate. The majority of small enterprises are structured as pass-through entities such as limited liability companies or S corporations, where profits are taxed according to the owner’s personal rate. While there is some tax relief in the bill for those pass-through firms–including a temporary ability to deduct up to 20 percent of income–many could access the permanent cut by converting to full-blown C corporations. . .

“I do believe it’s an amazing loophole,” says Anne Zimmerman, founder and CEO of the Cincinnati-based small businesses accounting firm Zimmerman and Co., who is recommending that some of her clients convert to C corps.

This could be huge. Mind you: Pass-through businesses like LLCs and S Corps account for more than 95 percent of all of America’s businesses in 2012. This strategy will not be appropriate for all LLCs and S Corps though.

Some suggest that if your business generates income of less than $315,000, you are already insulated from having to pay higher taxes, since the pass-through deduction will generally apply. “If your annual gross income [AGI] is less than that, there’s probably very little you need to do as far as re-structuring,” Marcum’s Reitmeyer says. “You’ll have no [deduction] limitations.”

UPDATE: If you want a mind-numbing walk-through of the taxation calculus involved for just one phrase of the new law which will be encountered by accountants in 2018, read this article entitled: “Tax Geek Tuesday: Making Sense Of The New “20% Qualified Business Income Deduction.”

Regardless of how the plan may have been sold to the public, the foundation of the recently-enacted Tax Cuts and Jobs Act was the reduction in the C corporation tax rate from 35% to 21%. But Congress couldn’t do this in isolation, because such a a one-sided dramatic decrease would cause the business playing field to tilt, with sole proprietors and owners of flow-through entities losing much of their advantage over their corporate competitors. To wit, the effective combined rate on corporate owners would become 39.8% (21% + (79%*23.8%), while the top rate on ordinary individual income — the rate applied to the income of sole proprietors and owners of flow-through entities, whether distributed or not — would become 37%. Thus, the advantage of a single level of taxation would shrink from 10% to just 2.8%. . .

After the House and Senate initially approached the non-corporate tax break from very different angles, the final law found some common ground, resulting in the creation of Section 199A, a new provision of the Code. On its surface, Section 199A will allow owners of sole proprietorships, S corporations and partnerships — and yes, even stand-alone rental properties reported on Schedule E — to take a deduction of 20% against their income from the business. The result of such a provision is to reduce the effective top rate on these types of business income from 40.8% under current law to 29.6% under the new law (a new 37% top rate * a 20% deduction= 29.6%).

Courtesy of this new deduction, sole proprietors and owners of flow-through businesses retain their competitive rate advantage over C corporations: it is 10% under current law, and will be 10% under the new law (39.8% versus 29.6%).

This is an overly, highly, incredibly broad summary of the law change. Read that article and it will dispel the “File your Taxes on the Postcard argument.” This law could be called the Tax Accountant Full Employment Act.

Converting an LLC or S Corp to a C Corp in Alabama can be quickly performed. Alabama has a statutory procedure to convert an LLC to a corporation.  Alabama allows what is called “statutory conversion.” You do not need to separately form a corporation before the conversion can occur. (As the conversion statute puts it, a converted entity [the new corporation] “is for all purposes the same entity that existed before the conversion.” Per 10A-1-8.01:

The terms and conditions of a conversion of a limited liability company to another entity must be approved by all of the limited liability company’s members or as otherwise provided in the limited liability company’s governing documents.

Accordingly, if you have an LLC or S Corp, you need to seriously consult your accountant and/or tax advisor to ascertain the tax consequences of each entity for your situation.