When Does It Make Sense to Form a “C” Corporation?
Limited Liability Companies (LLCs) and S Corporations (S Corps) are all the rage nowadays, and that isn’t without good reason. Most of the time, the traditional “C” Corporation (C Corp) doesn’t make sense for the business owner. Most people don’t fully understand why this is the case. And, they certainly don’t seem to understand what the possible advantage of a C Corp might be. Let’s take a minute to look at the advantages and disadvantages of a C Corp. I hope that this article will help you to understand better why anyone would ever form a C Corp instead of an LLC or an S Corp. First, we will review the major disadvantages of a C Corp:
- C Corps are subject to double taxation. The corporation itself pays tax. Next, the after-tax earnings are paid as dividends to the shareholders (owners), and those dividends are then taxed again! Therefore, double taxation.
- Except in very uncommon and specific circumstances for Personal Service Corporations (PSCs), the C Corp is required to use an accrual basis of accounting, as opposed to being able to choose between an accrual basis and a cash basis.
- C Corps with certain types of income, such as interest, dividends, rents and royalties, are potentially subject to the personal holding company tax on such income.
- The difference between a C Corp’s adjusted current earnings and its taxable income is mostly (75%) a tax preference item for purposes of the alternative minimum tax (AMT).
The biggest hurdle here is the double taxation. That can be overcome in certain circumstances, but that needs to be very carefully planned out. Now, let’s get to the meat of this article…let’s look now at some of the potential major advantages of a C Corp:
- The ability to split income. If you don’t plan to distribute all of the profits from your C Corp, you might benefit from utilizing a strategy known as “income splitting.” The idea is to split the business’s income so that part of it is taxable to the corporation and part of it is taxable to the corporation’s owner(s). Thus, putting them each in a lower tax bracket than they’d be in if either one was earning ALL of the income.
- A C Corp can deduct amounts paid for fringe benefits for its employee/owners, such as medical insurance or medical reimbursement plans, disability insurance, or group term life insurance. (Except for expenses paid on behalf of employees that are 2%+ shareholders)
- Election of a fiscal tax year. Other entity types must almost always be on a calendar year.
- Deductibility of dividends received. C Corps can deduct up to 80% of the dividends they receive from investments in other domestic C Corps. The deduction is 100% if the shareholder is a small business investment company as defined by the IRC.
- Unlimited number of owners. To ensure that the company’s growth is never impeded.
- 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. This is often times also very helpful in raising capital, as there are different participation options for investors.
- Common Stock – one vote per share
- Preferred Stock – usually does not come with voting rights
- “Class A” or “Class B”(different classes of stock) – usually carry different number of votes per share
- 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. There are also other strategies of netting gains/losses, corporate profits, and dividends received between affiliate corporations that is beyond the scope of this article. Ever hear how some large blue chip companies pay 5% or 0% tax?
- Section 303 to pay estate tax. This permits a corporation to redeem all or a portion of a decendent’s stock such that it will not be taxed as a dividend. 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.
So, when someone tells you that C Corps are used for more complex situations, that is not necessarily untrue. But, if a C Corp is being recommended to you, you better ask good questions and make sure you understand exactly why the C Corp route is best for you. 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 out strategy for taking advantage of its unique position in the tax code. One last commentary on forming a business…I spend a lot of time fixing compliance problems for clients that had someone else setup 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, and the clients are expecting it all to be done, but it is not. Thoroughness will pay off for you in the long run….
Good post. I’m dealing with many of these issues as well..
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