The 2018 tax reform bill passed by Congress brought a lot of new changes to federal taxes for California cannabis businesses. You may have some questions about how to take advantage of these changes, which is why we’re covering all new deductions, liabilities, and tax considerations in ongoing blog updates. Today: should you convert your S-Corp to a C-Corp?
Background: types of business entities
As a quick refresher, there are a number of different ways to structure your cannabis business. The way you set-up your new venture has significant tax implications. Here is a quick, high-level overview of some of the most common business structures you might consider forming:
- Sole proprietorship: in this simple, straightforward structure, a business is owned and operated by one person (you). There are generally no forms, agreements, or documents you specifically need to file to register as a sole proprietor. That said, you are personally liable for any business debts and obligations – should your business fail, your personal assets can be treated as business assets (e.g. creditors can go after your personal assets).
- General and Limited Partnerships: this structure is one level up from a sole proprietorship. It’s still relatively simple, in that it’s an association of two or more people running a business and jointly sharing the responsibility and liability for the business’s obligations. Whether the partnership is “limited” or “general” depends on the level of liability or ownership each partner takes on. In each of these scenarios, the business’s taxes are filed separately from the individuals though income and loss are passed through to the individual partners.
- LLCs and LLPs: an LLC (limited liability corporation) and LLP (limited liability partnership) each must register with the state. In an LLC, individual members are protected from liability within the business as long as the business is registered with the state and obeys state regulations. There aren’t as many formal restrictions as a registered corporation, and, as in an LLP, partners are no longer liable for the behavior of other partners.
- C-Corps: usually when you think of a typical business, the structure you’re picturing is a C-Corporation. In this structure, the business is owned by individual shareholders who have stock in the company. Shareholders vote on the direction of the company, and final decisions are made by a Board of Directors (who are usually elected by the shareholders). As with LLCs and LLPs, the shareholders are not personally responsible for debts and obligations of the company.
- S-Corps: last but not least, an S-Corporation is a bit of a different beast. It’s a tax election, meaning that corporation, LLC or LLP is created at the state level and decided to be taxed under that heading. S-Corps are treated as passthrough entities when taxed. By filing a federal form 1120-S, the income or loss from the business is passed along to shareholders who then report that information on their individual tax returns, thereby avoiding double taxes on personal and business income.
This is a very high level overview of the options available to your business, and if you have specific tax questions for the structure of your cannabis business, we suggest consulting with one of our experts. Let’s move on to the latest tax reforms – and how they impact S-Corps and C-Corps.
2018 Tax Reform Updates
Traditionally, small businesses have been encouraged to avoid filing a C-Corporations due to the double taxation issue. S-Corps have always been more appealing business structures for anyone looking for a lower tax rate: typically, individual income tax rates are much lower than business income tax rates. Therefore, especially for small businesses that don’t qualified for the reduced corporate tax rate, setting up a structure where you can claim business income as personal helps owners save money on federal taxes.
Congress’s tax reforms in January, 2018 changed that. The tax reforms reduced the corporate tax rate from a maximum of 35% to 20%. Many individual tax rates can reach up to 42%, the tables have turned, and now a 20% tax rate looks more appealing to many business owners who want to avoid paying higher tax rates on their income.
Should you convert to a C-Corp?
Note that there is some tax relief planned for S-Corps as well. The new tax bill included a temporary provision allowing pass-through entities to deduct up to 20% of their income on their return. This is known as the “qualified business income” deduction (and also applies to partnerships and sole proprietorships). However, this is a temporary provision: and making the switch to the C-Corps would allow your business to access a lower long-term tax rate.
Likewise, there are a variety of other deductions that S-Corps and C-Corps businesses can take advantage of. For example, C-Corps can claim the foreign income tax deduction and dividends-received deduction on the repatriation of foreign income where the US Corporation owns 100% of the foreign company. The latest tax reform suggests the current administration and Congress is doing its best to ease regulations on traditional corporations – something your cannabis startup may inevitably benefit from.
How do you convert to a C-Corps?
It’s relatively straightforward to convert an existing company to a C-Corporation in California. The process starts when you file a set of articles of incorporation with the California Secretary of State. You can read more about the process on the California Franchise Tax Board website.
Of course, before making any major business decisions, we recommend consulting with an expert to understand the full implications of your tax liability and business obligations. Filing as a C-Corps may lead to tax benefits, but this business entity comes with lots of other responsibilities.