Is It Time to Terminate Your S Election?
By Thomas W. Garton & Matthew L. Stortz
A lot of ink has been expended on the topic of whether, under the new tax legislation, a business operating as an S Corporation should, or should not, terminate its S Election and go forward operating as a C Corporation. Community bank officers, directors and owners are among those business folks struggling to get their arms around this issue. This is particularly true in Minnesota and the Midwest in general, where an outsized proportion of the country’s Subchapter S banks reside.
A good place to start an analysis of this question is to recognize that the answer is far from clear. There are many variables that will be specific to a particular bank or bank holding company. A careful analysis, and probably some crystal ball gazing, will be necessary to reach an informed decision.
The question begs analysis because the relationship between corporate tax brackets and individual tax brackets has shifted as a result of the recent tax legislation effective for 2018. The pre-2018 corporate tax rate (applicable to C Corporations) topped out at 35 percent. Under the new rules, that top bracket has been reduced to 21 percent. For individuals, the pre-2018 top bracket of 39.6 percent has been reduced to 37 percent.
Old S Corp Model
Prior to the 2018 change, the income of an S Corporation, which is taxed only to the individual shareholders, was subject to the individual tax rates that topped out at 39.6 percent. There was, and continues to be, no corporate level tax for S Corporations, and the earnings can be distributed to the shareholders without further tax. If not distributed, the income taxed to the shareholders increases the shareholders’ basis in their stock. This increased basis would be available to shelter capital gain on any later sale of the stock by the shareholder. The result was that the earnings of the corporation were able to be received by the shareholders (either through distributions of earnings or ultimately upon sale of the stock) with only one tax at the individual rate (maxing out at 39.6 percent) burdening the corporation’s earning.
Old C Corp Model
Prior to 2018, a C Corporation’s earnings were taxed at rates that topped out at the highest marginal rate of 35 percent. If the after-tax earnings were then distributed to the shareholders as dividends, an additional 20 percent individual tax on dividends would be due on those distributions. Stock basis is unaffected by corporate earnings in a C Corporation, so a shareholder receiving the economic benefit of those retained undistributed earnings as a component of the value of stock sold in a later stock sale would also be subject to the 20 percent capital gain rate. Using these top marginal rates as the measure, the overall tax burden on corporate earnings in order to get the earnings into the hands of a shareholder was 48 percent.
Old Rate Differential
It is pretty clear why many owners chose S Corporation status. By the above measure, the S Corporation model created an effective maximum tax rate 8.4 percentage points lower than the C Corporation model.
New C and S Corp Models
For the C Corporation model, the rate changes enacted for 2018 and beyond reduce the tax burden from 48 percent to 36.8 percent, which is a significantly favorable shift in the C Corporation model.
In the S Corporation model under the new law, in addition to the individual tax bracket reductions for individuals described above, the owners of many pass-through entities (partnerships, LLCs and S Corporations) will be able to deduct 20 percent of the income passed through to them. Assuming an S Corporation shareholder is eligible for the full 20 percent deduction (and the shareholders of most S Corporation community banks would be eligible), the maximum tax rate for the S Corporation model would be 29.6 percent, also a significantly favorable shift in the S Corporation model.
New Rate Differential
The new rate comparison yields the conclusion that the S Corporation model creates an effective tax burden at the highest brackets that is 7.2 percentage points lower than the C Corporation model.
As far as it goes, this analysis demonstrates that the benefit of the S Corporation model is reduced from 8.4 percent of corporate income to 7.2 percent of corporate income. This slight reduction in the S Corporation tax advantage seems unlikely to drive a decision to terminate S Corporation status.
The analysis based on the C Corporation and S Corporation models above is only the beginning of the process of answering the question whether the owners of an S Corporation should revoke the S Election.
First, the corporation should build its own model, utilizing anticipated corporate and shareholder income levels to determine the actual effective tax rates rather than the top marginal rates used in the analysis above. Applicable state income taxes should also be considered.
Second, the corporation should determine the availability to its shareholders of the new 20 percent pass-through deduction. The availability of this deduction will depend upon certain factors determined at the corporate level. Also, because the tax benefit of the deduction is partially dependent on the income of each particular shareholder, the results may not be the same for all shareholders. If the 20 percent deduction were not available, and the analysis of the top marginal brackets used above were applied, the S Corporation model rate would be essentially equal to the C Corporation rate of 36.8 percent.
Third, the models assume that all net earnings will be distributed. If the corporation plans to accumulate earnings for business expansion or acquisitions, C Corporation status could be significantly more favorable in the long run than S Corporation status. The top corporate bracket of 21 percent (assuming no dividends are distributed) is below the top individual bracket of 29.6 percent applicable to earnings of an S Corporation. The 20 percent shareholder C Corporation tax burden on distributions would be postponed until a later time, thus delaying the obligation to pay a portion of that C Corporation model tax burden.
Other considerations could be relevant such as the expected timing of any plans to sell the company and the anticipated transaction structure (if that can be predicted) of any proposed sale plans. A clear justification should be established before terminating an S Election because once an S Election is terminated, the corporation is prohibited from re-electing for five years.
There are a lot of details to consider before deciding to abandon S Corporation status. Careful analysis is important and will not be easy, but the opportunity should not be ignored. Just keep in mind there is no single best answer applicable to all banks.