Mass S-Corp Conversions? Not Yet, But Wait ‘til the Deduction Expires

The headline is eye-grabbing, but what does it mean?

A new study by Penn Wharton predicts a “mass conversion” of pass-through businesses to C corporation under the new tax law.  Specifically, the study finds that 235,780 pass-throughs representing 17.5 percent of all pass-through income will convert to C corporation in response to the new rules.

What sort of businesses are most likely to convert?  Those professional services businesses that don’t qualify for the new deduction.  Faced with a choice between paying the pass-through rate of around 40 percent and a corporate rate half that much, they are understandably attracted to the lower rate, particularly if they have the ability to defer paying out dividends.

Key points reported by the authors:

  • “We project that the Tax Cuts and Jobs Act (TCJA) will cause 235,780 U.S. business owners—77 percent of whom have incomes of at least $500,000—to switch from pass-through entity owners to C-corporations, primarily to take advantage of sheltering their income from tax by converting to C-corporations.
  • The biggest switchers include doctors, lawyers and investors, especially if owners can afford to defer receipt of business income to a later year. Other business owners, who are qualified to use the 20 percent deduction for pass-through business income, including painters, plumbers, and printers, are more likely to remain as pass-through entities.
  • We project that about 17.5 percent of all pass-through Ordinary Business Income will switch to C-corporations.”

So we’ve come full circle.  The C corporation is the new tax avoidance vehicle for highly-paid professionals, just like it was pre-1986.

But what about the headline?  We’re not sure how “mass” this conversion is, given that there are more than four million S corporations and nearly that many partnerships and LLCs.  Their estimate is less than five percent of the total population here.  Less than one percent if you include sole proprietors.

Moreover, we already knew the new tax bill shifted the equilibrium between pass-throughs and C corporations.  Every S corporation we work with is considering converting.  We have yet to hear of a C corporation going the other way.

For S-Corp, the news here is less about doctors and accountants and more about what it says will happen if the pass-through deduction is allowed to expire.  This study makes clear the dramatic separation in outcomes for those pass-through businesses that get the deduction and those that don’t.  For businesses that get the deduction, entity choice is a close call.  For those that don’t, there really is no decision—they will all be C corporations.

A 21-percent corporate rate without an off-setting pass-through deduction will push the business community in the wrong direction—towards the harmful double corporate tax rather than away from it.

Which is why the law’s authors need to start pressing for permanence now.  The deduction is slated to expire in eight years, which might seem like a long time, but multi-generation businesses plan in decades, not years.  For them, the temporary nature of the deduction plays a significant role in their planning right now.

So pass-through businesses are converting, just not “massively”.  The real “mass” conversion is yet to come, but only if Congress fails to act.

NOTE:  The Penn Wharton study has some good data, but they have the rates wrong.  The double tax on C corporations under the old law was 50.5 percent, not 58.8 percent.  Under the new law, it’s 39.8 percent, not 44.8 percent.  And that rate is only achieved by C corporations that pay out all their earnings immediately to fully taxable shareholders, which we know doesn’t really happen in the real world.  Businesses that need to distribute all their earnings to taxable shareholders are called S corporations.  By overstating the top corporate rate, the authors get the relative rate story wrong—its pass-through businesses that pay the higher amount under the new rules, not C corporations.

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