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C-corp vs S-corp: the §1202 question, post-TCJA

A 21% corporate rate narrowed the double-tax penalty, a new pass-through deduction rewired the other side, and §1202 did not move at all

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 8 sections
  1. What actually changed, in one paragraph
  2. The double-tax penalty is smaller, and that changes who should care
  3. §1202 is the column holding up the C-corp case
  4. §199A rewired the other side of the comparison
  5. Reasonable compensation is still the S-corp's load-bearing rule
  6. Where the presumption lands in 2019
  7. The rule of thumb
  8. Sources

C-corp pays 21% on the dollar it earns. An S-corp pays nothing at the entity level and pushes the dollar to its shareholders, who pay up to 37% on ordinary income and, if the facts line up, deduct 20% of it under §199A before they do. That is the new C-corp versus S-corp math, and §1202 is the reason the headline rate is not the end of the story.

Our August 2016 piece on the §1202 question was written at a 35% federal corporate rate. The arithmetic has moved. The conclusion, for the specific set of companies §1202 was written for, has not.

What actually changed, in one paragraph

Public Law 115-97, signed December 22, 2017 and in force for tax years beginning after December 31, 2017, struck the graduated corporate rate table in IRC §11(b) and installed a flat 21% on every dollar of C-corp taxable income. The Act added a new IRC §199A that lets individuals, trusts, and estates deduct up to 20% of qualified business income from a domestic pass-through, subject to thresholds and a phase-out for specified service trades or businesses. The Act did not touch IRC §1202, which still excludes the greater of $10 million or 10x basis in gain on the sale of qualifying C-corp stock held more than five years, and still excludes it only from C-corps.

That is the whole bill for present purposes. Everything below is downstream of those three facts.

The double-tax penalty is smaller, and that changes who should care

Under the prior regime, a dollar of C-corp income distributed to a top-bracket shareholder lost 35 cents at the entity and then 23.8% of the remaining 65 cents to qualified dividend rates plus the §1411 net investment income tax, leaving about 49.5 cents. The combined federal rate on fully distributed corporate income was 50.5%. A pass-through owner in the top bracket under old §1 paid 39.6% once, and kept the rest.

At 21%, the same dollar leaves 79 cents at the entity level and 18.8 cents of shareholder tax at distribution, for a combined federal rate of about 39.8%. The pass-through owner under new §1 pays 37% on ordinary income, or 29.6% if the full §199A deduction is available, and keeps the rest once.

The spread between distribute-it-all-C-corp and distribute-it-all-pass-through shrank from roughly eleven points to roughly three, and with the §199A deduction in play the pass-through still wins by about ten. Double taxation is still more expensive than single taxation. It is no longer expensive enough, by itself, to determine the answer for a company that does not distribute everything it earns.

For a founder planning to retain and reinvest, the 21% rate is its own argument. A dollar earned and kept inside a C-corp is taxed once, at 21%, and sits there funding headcount or capex until a distribution or sale event fires the second layer. A dollar earned inside an S-corp passes through to the shareholder's 1040 whether the shareholder sees the cash or not; the shareholder owes tax on retained earnings they cannot spend. That asymmetry tilts toward the C-corp whenever the business meaningfully reinvests, and it tilts harder the higher the shareholder's personal rate.

§1202 is the column holding up the C-corp case

The exclusion in IRC §1202 still belongs only to stock of a domestic C-corporation, issued directly by the corporation to the taxpayer, held more than five years, in a company with aggregate gross assets of $50 million or less at issuance, where at least 80% of assets are used in an active qualified trade or business, and where the trade or business is not on the excluded list: health, law, engineering (then removed from the list by cross-reference, though the §1202 text still includes it), accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, banking, insurance, financing, leasing, farming, mineral extraction, and hospitality. A taxpayer may exclude the greater of $10 million of gain per issuer or ten times the aggregate adjusted basis in the issuer's stock.

The PATH Act of December 2015 made the 100% exclusion permanent for stock issued after September 27, 2010. TCJA did not touch it. There is no expiration date on the rule, no sunset paired to §199A, and no reason to expect one; the provision has bipartisan political history and survived a 1,100-page tax rewrite unamended.

At 35%, §1202 was a reason a founder might tolerate the C-corp drag to get a ten-million-dollar exclusion at the end. At 21%, the tolerance cost is much smaller and the reward is identical. A founder with $7 million of gain at sale keeps $1.67 million more than the same founder operating through an S-corp that pays capital-gains tax on the full $7 million at 23.8%. Where the facts permit §1202, the C-corp is the cheaper form, not just a defensible one.

An S-corp cannot inherit a §1202 clock. The stock must be C-corp stock when issued, and the five-year holding period runs from that issuance. Founders who elect S early with the intent to convert later, then sell within five years of converting, receive nothing from §1202. This is the most common way the provision is lost, and it was true in 2016 and is true now.

§199A rewired the other side of the comparison

For tax years beginning after December 31, 2017 and before January 1, 2026, §199A lets individuals, trusts, and estates deduct up to 20% of qualified business income from a domestic pass-through. Below the 2019 taxable-income thresholds of $160,700 for single filers and $321,400 for joint filers (indexed from the 2018 thresholds of $157,500 and $315,000 under Rev. Proc. 2018-57), the deduction is available regardless of whether the business is on the specified-service list. Above the thresholds, the deduction is limited to the greater of 50% of W-2 wages paid by the business or 25% of wages plus 2.5% of the unadjusted basis of qualified property, and it phases out entirely over a $50,000 single / $100,000 joint range for any specified service trade or business (SSTB) under §1202's familiar excluded-industry list.

The practical effect is a bifurcated incentive. A pass-through owner below the threshold who runs a qualifying business gets an effective top federal rate of 29.6% on ordinary income. A pass-through owner above the threshold in an SSTB pays the full 37%. A pass-through owner in a non-SSTB above the threshold with a sufficient wage base also gets the full deduction and lands at 29.6%. A software company S-corp where the owner draws a reasonable salary under Watson v. Commissioner may or may not qualify depending on whether software counts as a specified service, which §199A expressly defines narrowly (the §1202 language is broader), and on the Treasury regulations finalized January 2019 in T.D. 9847.

The result is that §199A did what a 21% corporate rate could not: preserved the pass-through advantage for a wide class of operating businesses that distribute their earnings, while giving the C-corp a clear lane for companies that retain them or sell the stock.

Two facts about §199A are worth keeping in the founder's head. First, the deduction sunsets December 31, 2025. The 21% C-corp rate does not. A business expected to be operating past 2026 is pricing in a scheduled rate snapback on the pass-through side and nothing on the C-corp side. Second, §199A applies only to shareholders, not to the entity. A C-corp cannot take it, and neither can its shareholders on their dividends or wages. Any comparison that gives §199A to both sides is wrong.

Reasonable compensation is still the S-corp's load-bearing rule

The S-corp's payroll-tax advantage is real and is the reason most profitable small-business owners elect it. A shareholder-employee draws a salary subject to FICA and Medicare, then takes the remaining profits as distributions that are not subject to self-employment tax. The savings scale with the share of profits classified as distribution rather than wage.

The constraint is the reasonable-compensation requirement. Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012), is the case the IRS points to. David Watson, a CPA and sole shareholder of an S-corp that was a partner in a four-partner accounting firm, paid himself a $24,000 salary in 2002 and 2003 while his S-corp received distributions of $203,651 and $175,470 in those years. The Eighth Circuit affirmed the district court's recharacterization of a significant portion of those distributions as wages, on the strength of an expert report that concluded a reasonable salary for Watson's work was $91,044. The shortfall was assessed as additional FICA, penalties, and interest.

Watson did not create new law; it applied the long-standing rule that an S-corp shareholder performing services must receive a reasonable salary for them. Rev. Rul. 74-44 put the principle in writing in 1974. The IRS's Fact Sheet 2008-25 catalogs the factors courts weigh. The case matters because it is recent, the facts are modest, and the outcome is unambiguous: the payroll-tax savings are real, they stop where reasonable compensation begins, and audits of S-corp undercompensation are a durable enforcement priority.

The §199A wage-based phase-in adds a second reason to pay a reasonable salary. Above the taxable-income threshold, the §199A deduction is capped in part by 50% of W-2 wages paid by the business. A shareholder-employee who under-pays themselves to avoid FICA may also cap out of §199A. The two rules pull in the same direction, and the optimum for a high-income S-corp owner is usually a wage that is both defensible under Watson and high enough to unlock the full §199A benefit.

Where the presumption lands in 2019

Three buckets, each with a different answer.

A venture-bound startup aiming at a multi-year hold and an institutional sale should form as a Delaware C-corp, issue founder stock on day one, file the 83(b), and start the §1202 clock. This was true in 2016. It is more true now, because the annual drag of being a C-corp while the clock runs is smaller at 21% than it was at 35%. Anything where expected founder gain could exceed roughly a million dollars at exit, and the business is not on the §1202 excluded list, belongs in a C-corp.

A profitable lifestyle or cash-flow business that distributes most of what it earns and does not plan to sell the entity belongs in an S-corp or an LLC taxed as an S-corp. The §1202 exclusion does not fire if the entity is never sold; the 21% rate is not competitive with a 29.6% pass-through rate under §199A; and the payroll-tax savings on distributions past a reasonable salary are a real and recurring advantage. The C-corp revisited piece from January 2018 walks the distribution math in detail.

The middle case is a business that will retain earnings and may or may not sell. A software company reinvesting heavily, for instance, or a manufacturer building capacity. At 21%, retained earnings cost much less than they did, and the C-corp's ability to tax retained earnings once rather than flow them through to a 37%-bracket owner who cannot spend them is a genuine structural advantage. If the same business might also clear §1202 at exit, the C-corp wins on both ends. If the owners want the cash out every year, it does not.

The rule of thumb

If the business could plausibly be sold for enough that any one founder clears roughly a million dollars of gain, and the business is not on the §1202 excluded list, form a C-corp. Otherwise, S-corp for the distribution-and-payroll-tax math, and draw a salary the Watson court would have signed off on.

Sources

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