State Tax Savings of an S Corporation to C Corporation Conversion

What are the state tax benefits and disadvantages of converting an S corporation to a C corporation? The Tax Cuts and Jobs Act (TCJA) reduced the federal corporation tax rate. The reduced rate creates possible federal tax savings for S corporations that convert to a C corporation. The state tax benefits of such a conversion are less clear.

Each taxpayer will need to determine if converting to a C corporation for the lower federal rate will lead to greater tax savings.

What are the State Tax Rates for S Corps and C Corps

States have not enacted the same dramatic corporate rate tax cuts as the federal government. Converting to a C corporation could actually lead to an increased tax burden in some states. Many state’s personal income tax rates, the rate S corporation shareholders pay, are lower than the state’s rate for C corporations. States with a higher corporate rate include:

  • Illinois;
  • Indiana; and
  • Pennsylvania

Pennsylvania has a 9.99% corporate rate and a 3.07% personal rate. A difference in rate that likely makes a conversion unattractive.

Other states have the same corporate and personal rate, leading to no difference in tax rate, including:

  • Colorado;
  • Mississippi; and
  • Utah.

Finally, in many states the personal rate could be lower than the corporate rate depending on the taxpayer’s income level.

The first step when considering an S corporation conversion is to determine a shareholder’s tax rate.

Can State Taxpayers Take the Qualified Business Income Deduction?

Most states have determined that the federal qualified business income deduction will not apply when calculating state taxes. The TCJA created a 20% deduction for owners of pass-through entities. The deduction is intended to address the difference between the federal corporate and personal income tax rates. Taxpayers take the deduction after determining adjusted gross income.

However, states typically use federal adjusted gross income, federal taxable income, or federal gross income as the starting point to determine personal income tax. Taxpayers take the federal qualified business income deduction after that point. Thus, the deduction mostly does not apply at the state level and it would affect the decision, from a state tax perspective, on whether to convert an S corporation to a C corporation.

Converting an S Corporation to a C Corporation, Possible Negative Consequences

In many states converting an S corporation to a C corporation does not take long. Some states recognize the federal S corporation election. Virginia follows the federal revocation, while New York requires the filing of a revocation form.

Taxpayers should make sure that they want to revoke S corporation status. Following a revocation, many states require a 5 year wait before returning to S corporation status.

There are also some downsides when converting an S corporation to a C corporation. These include:

  • double taxation;
  • possible loss of other tax benefits; and
  • administrative issues.

Like at the federal level, converting an S corporation to a C corporation can lead to double taxation. States tax income when it is earned by the corporation and when paid as dividends.

Some states also limit current tax benefits when there is a conversion. For example, Oregon limits the carryover of tax credits.

Finally, each state has its own requirements to register and maintain a C corporation. Taxpayers choosing to convert will need to research and make sure to comply with those requirements.

By Andrew Soubel, J.D.

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All stories by: CCHTaxGroup