Limited liability companies (LLCs) and S corporations are all the rage nowadays, and with good reason. Most of the time, starting a traditional C-corp doesn’t make sense for the modern business owner. Most people don’t fully understand why this is the case. Let’s take a minute to look at both the advantages and disadvantages of forming a C corporation. First, we will review the major disadvantages:
- C-corps are subject to double taxation.The corporation itself pays taxes. Next, the after-tax earnings are paid as dividends to the shareholders (owners), and those dividends are then taxed again.
- The C-corp is required to use an accrual basis of accounting. This is as opposed to being able to choose between an accrual basis and a cash basis. Personal Service Corporations (PSCs) are the exception here, in very uncommon and specific circumstances.
- C-corps with certain types of income are potentially subject to the personal holding company tax on such income. This includes interest, dividends, rents and royalties.
- The Alternative Minimum Tax sets a limit on how many tax benefits C-corps can receive. The difference between a C-corp’s adjusted current earnings and its taxable income is mostly (75 percent) a tax preference item for purposes of the Alternative Minimum Tax (AMT).
The biggest hurdle here is double taxation. That can be overcome in certain circumstances, but they need to be very carefully planned out. Now, let’s look at some of the potential major advantages of a C-corp:
- You can play the tax bracket game.If you don’t take out all of the profits from your C-corp, you might be able to place two pieces of the income in different tax buckets. The idea is to strategically allocate the C-corp’s income so that part of it is taxed at the corporate rate and the other part is taxed to the corporation’s owner(s). This will lower the overall tax bill.
- A C-corp can deduct amounts paid for fringe benefits for employees/owners. This includes medical insurance or medical reimbursement plans, disability insurance, or group term life insurance (except for expenses paid on behalf of employees who are shareholders of two percent or more of the business).
- C-corps can elect a fiscal tax year. Other entity types must almost always be on a calendar year.
- They have the ability to deduct dividends received. C-corps can deduct up to 80 percent of the dividends they receive from investments in other domestic C-corps. The deduction is 100 percent if the shareholder is a small business investment company as defined by the IRC.
- They can have an unlimited number of owners. This term exists to ensure that the company’s growth is never impeded.
- There are multiple classes of equity. In a C-corp, there can be different classes of stock to reflect the desire for only some shareholders to participate in company business. This can be helpful in keeping decision making in one class, but enable participation in earnings with an additional class. It’s also very helpful in raising capital, as there are different participation options for investors. For example, a common stock usually has one vote per share, a preferred stock usually doesn’t come with voting rights, and a “Class A” or “Class B” stock usually carries different numbers of votes per share.
- C-corps have the ability to file consolidated returns. Affiliate corporations can sometimes use unused losses and/or credits of one corporation to offset the income of another corporation. By using these losses, the group of corporations can receive immediate tax benefits instead of waiting for carryovers to provide the benefit in future years.
- A C-corp can redeem all or a portion of a descendant’s stock such that it will not be taxed as a dividend. This is under Section 303 — paying estate tax. Redemption under this strategy can provide cash for estate taxes and other expenses without the income tax consequences associated with the declaration of a dividend.
C-corps are often used for more complex situations. If someone recommends a C-corp to you, ask questions and make sure you understand exactly why it’s the best route. You don’t have to be a large company or have a large number of shareholders to benefit from being a C-corp. You just need to have a very specific and well-planned strategy for taking advantage of its unique position in the tax code.
One final note: I spend a lot of time fixing compliance problems for clients who had someone else set up their business and did the legal part and not the tax part (or vice versa). Make sure ALL of the compliance work and applications are filed with ALL the state and federal authorities. There are still a lot of professionals only doing part of the work. Thoroughness will pay off for you in the long run.
TAX ADVICE DISCLOSURE: Pursuant to requirements related to practice before the Internal Revenue Service, any tax advice contained in this communication (including any attachments) is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the United States Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax related matter addressed herein.
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