Beware of Subchapter C

Photo by Jodie Andruskevich

There are currently about 12,000 New Hampshire business corporations, of which perhaps 3,000 are subject to federal income tax as C corporations. There are also a very small number of single-member and multi-member LLCs taxable as C corporations. So perhaps as many as 10,000 New Hampshire business owners are C corporation shareholders.

It is safe to say that virtually none of them ought to be C corporations. This is because the Internal Revenue Code’s Subchapter C is a double-tax regimen: A C corporation’s income is subject to a 21% tax to the corporation itself, and when the corporation distributes its after-tax profits to its shareholders as dividends, its shareholders are taxable on these distributions.

So why are there so many New Hampshire C corporations and shareholders? The answer is unclear, but my guess is that the federal tax returns of many of these corporations are prepared by the shareholders themselves or by corporate officers or employees, many of whom may not be tax professionals. In other words, these C corporation shareholders just don’t know any better.

What federal income tax regimen should these C corporations have? Until Jan. 1, 2018, the answer would normally have been Subchapter S. First of all, Subchapter S, unlike Subchapter C, is a “pass-through” federal tax regimen; that is, its income is not taxable to it but only as annually allocated to its shareholders on a per-share basis.

S corporation shareholders must pay federal income tax on these allocations, but with rare exceptions, they do not have to pay tax on S corporation distributions, except the 5% New Hampshire interest and dividends tax.

However, as many readers will know, on Jan. 1, 2018, new IRC Section 199A became effective. It provides the owners of pass-through businesses with amazing federal income tax pass-through deductions — namely, deductions of up to 20% of their companies’ net business income.

Pass-through business owners include sole proprietors, S corporation shareholders, and individuals and trusts that are partners of entities taxable as partnerships, such as members of multi-member LLCs.

However, if individuals who are C corporation shareholders are married and if their joint taxable income does not exceed $315,000 ($157,500 if they are single) and if they want to obtain Section 199A deductions, they normally must convert their corporations not to S corporations, but rather:

• To single-member LLCs taxable as sole proprietorships if they are the only shareholders of their corporations, or

• To multi-member LLCs taxable as partnerships if their corporations have two or more shareholders

Furthermore, if they make the above conversions, not only will they obtain 20% federal income tax deductions under Section 199A, they will also avoid the I&D tax on distributions.

With rare exceptions, C corporation shareholders should convert their corporations to S corporations only if their taxable income exceeds the above Section 199A “threshold amounts” and if their corporations pay their employees significant W-2 wages or own and use valuable depreciable property.

However, if C corporation shareholders decide to convert their corporations to single-member LLCs taxable as sole proprietorships or to multi-member LLCs taxable as partnerships, they must do so by forming new LLCs or by converting their corporations to LLCs.

These conversions require the use of New Hampshire legal procedures called “statutory conversions,” and statutory conversions must be carried out in such a manner as to avoid or minimize potentially substantial federal income tax liabilities under IRC Section 336. Avoiding Section 336 can be tough, but it’s quite possible if you use the right structure.

However, the professional fees for handling these various legal and tax procedures can be significant. Fortunately, however, these fees will apply only in the year of conversion and not thereafter.

Are there ever situations when the shareholders of C corporations should not convert their corporations to a pass-through federal tax regimen, but rather, should choose the Subchapter C 21% federal tax rate over the tax rate they will owe under Section 199A?

In my view, they should do so only if they will probably never work for their corporations and thus will never owe federal taxes on their C corporation employment compensation and they will probably never need distributions of profits from them.

Needless to say, very few New Hampshire C corporations can meet these tests.

John Cunningham, a New Hampshire corporate and tax attorney of counsel to McLane Middleton, can be reached at 603-856-7172 or lawjmc@comcast.net.