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Clayton & McKervey is a full-service CPA and consulting firm servicing middle-market, growth-driven clients in the industrial automation sector. Based in Detroit we provide tax, accounting, assurance and business advisory services to closely held domestic and international clients. To learn more about Clayton & McKervey, visit claytonm

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C-Corp vs. S-Corp Tax Reform and R&E Credits

POSTED 11/07/2018

Tax Reform
The passing of the 2017 Tax Cuts and Jobs Act has many closely held business owners raising the question, “Should I convert to a C corporation?” On the surface, with the corporate tax rate now at a flat 21% and the highest individual tax rate at 37%, it would seem to be a “no brainer” that business owners would benefit by converting to corporations. However, additional factors should be considered before making such big decision. Such factors include:

  • Does the business qualify for the pass-through deduction
  • Is the business generating research credits
  • Will the business pay dividends to its owners
  • What is the long-term exit strategy?

Looking at the first two factors, the pass-through deduction provides a 20% deduction on qualified business income. If business owners qualify for this deduction the tax rate on business income that flows to their personal return will be reduced from 37% to 29.6%.

For many profitable businesses who pay wages to the business owner(s), beginning in 2018, their tax liability will look similar to the example provided in Figure 1:

Figure 1

When we consider the benefits of the reduced corporate tax rate, it appears that being a C-Corp is more favorable, even with the flow through deduction for partnerships and S-Corps. However, this doesn’t take into account companies that generate Research and Experimentation (R&E) tax credits.

Research and Experimentation Tax Credits
One common misconception about the 2017 tax law is that the R&E credit has gone away, which is not true. The R&E credit continues to be one of the best tools a taxpayer has to reduce their federal tax liability to a minimum tax rate, usually around 7.5%.

The basic premise of the R&E credit is that a business developing new or improved products, processes or techniques, can generate credits based on their qualifying research expenditures for that year. This includes wages, supply costs and contract research.

Figure 2 below, shows that when the R&E credit added to the above example, changing from a partnership or S-Corp to a C-Corp may not be the best solution.

R&E as a Tax Savings Tool
Here we see that utilizing the R&E credit results in a significant reduction of tax liability for the S-Corp or partnership, which raises another common question: “How does a flow through entity utilize a dramatically larger credit compared to the C-Corp if the amount of credit generated is the same in both entities?” The answer lies in the way the tax law is written. R&E credits generated by a business can be used to offset any income generated from that same business activity.

C-Corp
For a C-Corp, income generated is generally limited to the income of that business, therefore, the wages paid to the owner(s) cannot be offset by the credit. Additionally, if the business incurs a net loss for the year, credits can still generate, but there is no income to offset with those generated credits.

S-Corp
For an S-Corp or partnership, the income generated does not only include the business income, but also any wages, guaranteed payments and interest paid to owners. Even if the business incurs a loss, if wages were paid to owners, owners can still offset wage income with credits generated during the year.

In the example outlined above, for a C-Corp only the income tax reported on the business tax return can be reduced to a 7.5% minimum tax rate, and the wages paid are taxed at the 37% individual tax rate. $500,000 × 7.5% = $37,500. $200,000 × 37% = $92,500. $37,500 + $92,500 = $130,000. For the S Corp, both the business income and the wages can be reduced to a 7.5% minimum tax rate if the business generated enough credits. In this example federal tax could be reduced to as low as $56,250 because only $150,000 of R&E credits were generated, and the federal tax liability was reduced to $90,500.

Utilizing the R&E credit is a powerful tool business owners have to offset their tax liability, even under the new tax law. Before making the decision to change to a corporation, it is important to consider and have a conversation about the R&E Credit.

If you think it may make sense to convert to a C corporation but also believe you may qualify for R&E credits, or may not have utilized the credit to its fullest extent in prior years, contact Clayton & McKervey Shareholders Sarah Russell or Tim Finerty for a free assessment to determine your potential R&E credit.