The Tax Cuts and Jobs Act (TCJA) brings sweeping tax reform changes, and many of these changes favor C corporations. The most significant change is a reduction to corporate tax rates. For tax years beginning after December 31, 2017, the corporate tax rate will be reduced to 21% (from a maximum tax rate of 35%).
The reduction to individual tax rates under the TCJA pales in comparison. The highest individual tax rate will be reduced to 37% (from a maximum tax rate of 39.6%); therefore, depending on the marginal tax rate of its shareholder group, an S-corporation bank will be subject to much higher tax rates than a C-corporation bank.
This significant difference in tax rates begs the question: Does S-corporation status still make sense for my bank? Tax rates do not tell the entire story. To answer this question, the benefits of C-corporation status need to be compared side-by-side to the benefits of S-corporation status.
Benefits of C-Corporation Status
An obvious benefit of C-corporation status is the positive impact of a maximum 21% corporate tax rate, compared to a maximum 37% individual tax rate for S-corporation banks. On a million dollars of taxable earnings, this can translate to permanent tax savings of $160,000 (ignoring the new “pass-through” deduction, to be discussed below).
Besides reducing corporate tax rates, the TCJA also eliminates the benefit of state tax deductions for most individuals (capped at $10,000 per year). Thus, another ancillary benefit of C-corporation status is the fact that C corporations are not limited on their state tax deduction, whereas S corporations will be limited at the shareholder level. On a million dollars of taxable earnings, this can translate to another permanent tax savings of roughly $20,000.
Other benefits of C-corporation status for banks include the following:
• 3.8% Medicare Tax on Passive Income – C corporations are not subject to the 3.8% Medicare tax on passive income. S corporations, on the other hand, are potentially subject to this tax at the shareholder level, depending on the shareholder’s level of involvement at the bank.
• Deferred Tax Assets – C corporations can book a deferred tax asset for cumulative book/tax timing differences, thus having a significant positive impact on the bank’s capital.
• Tax Bad Debt Reserve – Eligible “small” banks are permitted to use a tax reserve method of accounting for bad debts, thus yielding additional tax deductions on their corporate tax return.
• Dividends Received Deduction – C-corporation banks are permitted to deduct 50% (sometimes 65% or 100%, depending on ownership percentage) of dividends received from other corporations.
• Fringe Benefit Treatment – S-corporation shareholders owning more than 2% of the outstanding stock must include certain company-provided fringe benefits in their gross income, whereas C-corporation shareholders do not.
• Accrued Expenses to Shareholders – An accrual basis S corporation cannot deduct accrued expenses to shareholders (e.g., salary, bonus, interest, etc.). An accrual basis
C corporation can deduct accrued expenses to shareholders owning 50% or less of the corporation’s stock.
• Eligibility Issues – An S corporation can only have one class of stock, cannot have more than 100 shareholders, and must be individuals, certain types of trusts and estates, or qualified nonprofit entities. A C corporation can generally have any number or type of shareholders.
• Administrative Cost – A C corporation has fewer administrative costs and professional fees associated with it, as compared to S corporations.
Benefits of S-Corporation Status
Many banks have elected S-corporation status. In the past, the S-corporation election was hugely beneficial, primarily due to two favorable tax provisions: 1) S corporations were not subject to “double tax” and 2) S-corporation shareholders received a stock basis increase for undistributed profits.
Dividends paid by a C corporation are generally subject to double taxation. First, C corporations pay tax on their taxable income, now at a maximum rate of 21%. When income is distributed to the shareholders as dividends, the shareholders pay a second tax on the same income, generally at a tax rate of 15% or 20% (plus another 3.8% for the Medicare surcharge).
S-corporation earnings are taxed only once—at the shareholder level. Undistributed earnings are recorded in the Accumulated Adjustments Account (AAA), a corporate level account. Because the earnings have previously been “passed through” to the shareholders and subject to tax on the shareholders’ returns, subsequent distributions of the earnings out of AAA are generally tax free.
Stock Basis Increase for Undistributed Profits
The shareholders’ tax basis in the stock of an S corporation is increased or decreased by the income or loss that is passed through to the shareholders. While generally not taxable, actual distributions of cash out of AAA reduce a shareholder's basis in the stock of the S corporation. Thus, another significant advantage of an S corporation is that undistributed income increases basis in stock and thereby reduces the recognition of gain on the disposition of the
S-corporation stock. This is very beneficial when S-corporation stock is sold.
Other benefits of S-corporation status for banks include the following:
• Pass Through Deduction – The TCJA provides a new 20% pass-through deduction for “qualified business income.” The provision is complicated and subject to numerous limitations and exceptions; however, most well-advised S-corporation banks and shareholders should be able to utilize this favorable tax provision. The impact is that 80% of the S-corporation earnings will be subject to tax, effectively lowering the highest individual tax rate from 37% to 29.6%.
• Elimination of Double Tax on Sale of Assets or Liquidation – A C corporation must first recognize a gain at the corporate level (and pay tax on the gain) when it sells assets and/or liquidates. If the net proceeds are distributed in liquidation, there is another tax at the shareholder level. The gain on the sale of assets (and on subsequent liquidation) by an S corporation is generally taxed only once at the shareholder level, other than gains subject to the built-in gains tax. This can be a significant benefit for an S corporation, especially after factoring in the basis step-up referenced above. This also makes an
S corporation more attractive to a potential buyer.
• Charitable Contribution Limitations – A corporation's charitable contribution deduction is limited to 10% of its pre-contribution taxable income. For an S corporation, the limitations are determined at the shareholder level and are significantly less stringent (a shareholder may deduct cash charitable contributions up to 60% of their adjusted gross income).
• Shareholder Interest Expense on Acquisition Debt – When a shareholder purchases the stock of a C corporation and borrows the funds to acquire the stock, the interest expense is classified as “investment interest.” In general, investment interest is only deductible against investment income. If the same shareholder borrows funds to purchase
S-corporation stock, the treatment of the interest expense follows the character of the income passed through from the S corporation (i.e., it generally offsets K-1 ordinary income and is deductible on Schedule E).
The TCJA brings sweeping tax reform changes. The significant decrease in the C-corporation tax rate has caused many S-corporation banks to question whether their choice of entity status still makes sense. To adequately address that question, the benefits of C-corporation status should be compared side-by-side with the benefits of S-corporation status, while also considering the long-term business plans for the bank. Tax advisors can be consulted to run an analysis over a multi-year period and to summarize the cost/benefit in a quantifiable manner. The results of this analysis can determine the answer to the question, “Does S-corporation status still make sense for my bank?”