The Ultimate C Corporation Handbook
By Diane Kennedy, CPA
Why Everyone Needs a C Corp or an LLC-C (Eventually)
Are you ready for a C Corporation? Typically,when your income puts you into the top federal tax brackets a C Corp starts to look attractive. The C Corporation can also be a good idea if you want better tax-free benefits to employee/owners than an S Corporation can give you.
That’s what is true right now, at the beginning of 2017. If we see tax changes as promised by President Trump and the Republican House, it is very possible that we will see some major changes in C Corporations. This is good news for anyone who has a business.
The purpose of this current C Corporation Home Study Course is to go over the basics of C Corporation tax strategies, so you’re ready to act quickly when the law changes.
This material is informational only. It is not meant, directly or indirectly, to provide formal legal and/or tax advice. Consult with your own attorney, CPA, and/or other advisor regarding your specific situation. We take reasonable precautions in the preparation of all material presented and believe it is accurate as of the date it was written. However, we assume no responsibility for any errors or omissions, and we specifically disclaim any liability resulting from the use or application of the information contained herein.
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The Best Business Structures for Business
If you have a business, the best structure for you is almost always going to be a corporate structure. Otherwise, you will pay self-employment tax of 15.3% on your business net income. It could be an S Corporation or a C Corporation or an LLC that has elected to be taxed as one of these (LLC-S or LLC-C).
But which is best?
10 Questions to Help ChooseC or S Corporation
Here are 10 things to think about before you make your decision between an S Corp and a C Corp:
- Are you earning more than $250-300,000 per year?
- Will you need all of the income from the corporation to live?
- Do you expect a lot of losses in the early years?
- Do you own any other C Corporations?
- Where do your shareholders (and potential shareholders) live?
- How many other people are going to be involved in this
business?
- Do you think your business may be suitable to take public at
some point?
- Do you have a lot of uncovered medical expenses?
- Do you have a need for staggered fiscal year-ends?
- Are you using the corporation to operate a licensed,
professional business?
Beware the Double Taxation Trap
Double taxation is something unique to C Corporations. Just like the name indicates, you run the risk of paying tax twice on the same income if you make this mistake with your C Corporation.
Here’s what happens. Your C Corporation is the only business structure that pays taxes at a separate, corporate income tax rate. Other structures like S Corporations or Partnership don’t pay tax separately. Instead, they flow their net profits (before tax) directly to their owners’ tax returns. Those net profits (or losses) are then
reported on the owners’ personal tax returns. In flow-through entities, the business’s profit is only taxed once.
But in C Corporations, that profit may be taxed twice. The difference occurs when an owner takes out some of the profit in the form of dividends. In the case of an S Corporation, dividends do not impact the taxability of income. If an owner takes a salary, the salary is income to the recipient and it’s an expense for the company. An S Corporationdistribution is not a tax deduction for the company and it is not income to the shareholder. It’s just simply a matter of taking cash out of the company.
A C Corporation, on the other hand, is taxed differently. The salary paid to an owner is a deduction to the company and income to the
shareholder, just like with an S Corp. A distribution from a C Corp, however, is a taxable dividend to the shareholder. The recipient pays tax. The C Corporation does not take a tax deduction for the dividend. It is paid out of already taxed profit.
Hence, the term “double taxation” is used to refer to dividends paid from a C Corp. This is generally something you want to avoid if you have a small, closely held C Corp.
As an investor, I look for corporations that pay dividends. I want to invest in companies that provide me cash flow, so I don’t care about the double taxation part of it.
If the C Corp is yours, though, dividends don’t provide any tax benefit and you will most likely want to avoid taking money out that way.
Are You Earning More Than $350,000 Per Year?
If your Form 1040 income is less than $350,000, including your anticipated income from this new business, then from a tax perspective you might not need a C Corporation. You can use the S Corporation to flow income through to yourself, in a combination of W-2 salary and profit distributions. You’ll have income tax on your salary and the taxable income from the company. However, you will only have payroll taxes on your W-2 income. Your profit distributions will flow through to you without additional payroll tax.
On the other hand, if your taxable income, including the income from this new business exceeds $440,000, you’ve moved into the top tax bracket. All income that falls into this bracket will be taxed at 39.6% federally. Now you might want to explore how the C Corporation tax structure could benefit you. C Corporations have their own tax brackets, which can belower than personal brackets.
For example the first $50,000 in net income in a C Corporation is taxed at 15%. If you had that same profit in an S Corporation, it would come through to you as a profit distribution and be taxed at your personal rate, which could be as high as 39.6%.
Do You Need All of Your Income to Live On?
If you don’t need every dollar of profit your company earns, you may be a great candidate for some advanced tax planning. What we’re talking about here is a Retained Earnings Strategy. With this strategy, you take a salary to cover your financial needs, and leave the rest (or most of it) in the C Corporation. In the right circumstances, it’s an easy way to save $12,500 (tax savings on $50,000) of tax.
But to make this strategy work, you need to be able to leave part of the C Corporation’s income in the business, as retained earnings.
C Corporations are the only entity that can choose whether or not to disburse the profits from the business. With S Corporations and the other flow-through structures, the IRS considers all the profit each year disbursed, and taxes you on it, even if you don’t actually distribute the money.
This is a common mistake regarding S Corporations, so I want to say it again. Salary will reduce the taxable income in an S Corporation. Distributions do not impact taxable income.
In a C Corporation, undisbursed profits are called retained earnings. C Corporations may retain up to $50,000 of after-tax profits each year with no tax consequences. (Once a C Corporation accumulates $250,000 in retained earnings it may become subject to an excess profits tax).
The great thing about retained earnings is your ability to divert that money into other business investments, real estate, loans, or a pension plan, for example. In each case, you can move the money from theC Corporation directly to anotherbusiness venture in the form of a loan. It never hits your personal return, and so there never is a capital gains tax issue for you.
For example, assume you wanted to use the excess profits to invest in a real estate venture. You could create a new LLC to hold the property, and then have the C Corporation make a loan to the LLC. Because the money went out of the C Corporation as a loan, it won’t be considered a taxable dividend to you personally. Plus, as the LLC repays the C Corporation that money won’t be considered taxable income to the C Corporation. The payment is simply a loan being repaid. This can be a powerful strategy for smart investors
Do You Expect a Lot of Losses in the Early Years?
Will your business lose money in the early days? There’s a reason most businesses begin life as S Corporations. That’s becauseC Corporations, unlike S Corporations, may not flow their losses through to the owners personally. Because the C Corporation pays tax at its own rate, it has to deal with the losses internally as well, and use them to offset its income. If the C Corporation has more losses than income, anything left over gets suspended, and carried forward until there is enough income to complete writing off the losses.
In an S Corporation, it’s different. Losses flow through to your personal return, just the same way profits do. Now, if you’ve got more losses than profit, the losses can be used to offset your other income.
This is something our high income clients love. The ability to take business losses against other active or passive income can really bring down their personal tax bills
The rule of thumb here is to first look at your current income level. If the business is your primary source of income and you are taking $50,000 or less out of the business, then an S Corporation is your choice.
If you have multiple sources of income and are already in a high tax bracket, and especially if you don’t need all of the income from the corporation each year, then the C Corporation may be worth looking at.
Do You Own Any Other C Corporations?
The controlled group is a gotcha that has snagged some of our clients. If you own a majority interest (50% or more) in two or moreC Corporations, your corporations will be considered a controlled group by the IRS.
When you (or a group of related persons) control multiple C Corporations a controlled group is created. For tax purposes, the C Corporations are all collapsed down into a single C Corporation. Now you have to add all of the individual business’s income together, and pay tax on that consolidated income at C Corporation rates.
Let’s say you had three C Corporations, and planned them out carefully to have $50,000 in net taxable profits in each. You should be able to file 3 separate tax returns, and pay 15% income tax on each Corporation’s net earnings. Right?
Wrong.
Under IRS controlled group rules, you would have to add all the income together, and then calculate your tax based on your new cumulative net income of $150,000. That’s going to move you up the corporate tax bracket ladder to 39% on part of that income
And, in addition to treating the C Corporations as one entity for calculating tax, you must also aggregate certain deductions as well.
For example, if you owned three C Corporations you’d have to spread one Section 179 deduction across all three corporations. Instead of having a potential of $1.5 million in deductions for 2017 ($500,000 x 3), you're limited to a single $500,000 deduction.
One bright spot in all of this concerns liability. While you might have to file a consolidated tax return for your multiple C Corporations, they are still treated as individuals legally. If one C Corporation is sued, that problem won’t automatically flow through to impact your other companies.
How to Avoid Controlled Group Status
The best way to avoid controlled group status is not to have a controlled group. If you already own 50% or more of a C Corporation, then make sure you set up your other entities as S Corporations or LLC-S’s. Because of their flow-through tax status, S Corporations and LLC-S’s are not subject to the controlled group regulations.
If you already have multiple C Corporations, you may be able to get some relief by changing your ownership around. For example, if a couple has two C Corporations, we will often recommend that each spouse or partner own one Corporation outright, and have no ownership in the second one. Make sure you’re following all of the attribution rules if you attempt this strategy. This is one thing you must get right and you will want an experienced tax professional helping you with the strategy and implementation.
Where Are Your Shareholders
If you have or are planning to have foreign resident shareholders, then the only way to do this is to use a C Corporation. S Corporations are not permitted to have non-U.S. taxpayers as owners.
If you expect to have non-U.S. residents owning even a small piece of your corporation, the C Corporation is your best bet. An S Corporation that is found to have foreign owners will be unilaterally converted to a C Corporation by the IRS, and will undoubtedly involve some headaches, emergency tax planning, and most likely a larger tax bill.
How Many Shareholders Will Your Business Have?
Another S Corporation limitation is on the number of shareholders it may have. S Corporations are limited to 100 shareholders only.
If you are looking to grow your corporation into a larger business, and, in particular if you are looking at taking it public or even carrying out private corporation financing (like a private placement offering), then a C Corporation is probably a better solution.
You can begin as an S Corporation and change to C Corporation status later. However, there will be additional accounting and bookkeeping costs as you switch the corporation’s records over to the new system.
Will Your Business Grow and Become a Public Company?
There is really only one way to go public, and that’s through a C Corporation. Nothing else is flexible enough to give you access to the widest possible shareholder base while maintaining control over business operations. Remember, S Corporations are limited in both the number ofshareholders and their locations. C Corporations, on the other hand, can have a limitless number of shareholders, who may reside anywhere in the world.
Another huge advantage C Corporations have over S Corporations is their ability to have multiple classes of stock, whereas S Corporations are limited to one type only. This can be helpful when you are trying to design a structure that will let you stay in control as your business grows and more shares are issued.
One common method is to issue preferred, non-voting stock to a corporation’s founders, which can then be converted to voting stock when the corporation goes public. Now the founders can stay in control, even after several new million public shares have been added to the corporation’s bank of issued shares (called a treasury).
Medical Expenses and Medical Insurance
If the ability to maximize loopholes and tax deductions is your overriding factor, then you should know that a C Corporation has more tax loopholes and deductions available to it than S Corporations, LLCs or LPs.
On example is medical insurance. C Corporations can establish a medical insurance plan and write off all of the costs associated with that plan. So can S Corporations. But, there’s a big difference in how those benefits are taxed.
In both cases, the amount of the premiums paid by your corporation is a deductible business expense. But, if you own 2% or more of an
S Corporation, and receive medical benefits through that Corporation, you are required to treat those paid premiums as a taxable benefit, and they are added to your yearly W-2.
In a C Corporation, the premiums paid for your healthcare are not considered taxable income to you.
Even the new healthcare legislation enacted in 2010 doesn’t change that. So, while your insurance costs may be $1,200 per month for yourself and your family, you don’t currently see an extra $14,400 reported on your W-2 each year. The C Corporation treats that $14,400 as a deductible expense. It’s part of its cost of doing business.
Medical Expense Reimbursement Plan
The Medical Expense Reimbursement Plan (MERP) is commonly confused with a regular medical insurance plan, but it is actually so much more. With a MERP, you can spend a certain amount each year on medical expenses and then be reimbursed directly from your
C Corporation for those expenses.
The annual amount is set by your C Corporation. So, let’s say you have a C Corporation where you and your spouse are the only employees. As long as you don’t control any other companies that have employees, you can offer yourselves unlimited MERP. Every qualifying medical expense that you incur, expected or unexpected, can be reimbursed bythe C Corporation for a full deduction. And, with your own plan, what you define as qualifying can be considerably broader than would be available through commercially-available healthcare plans.
The MERP isbetter than some of the other before-tax medical plans such as HSA, MSA, cafeteria or Section 125. With these other types of plans, you have an amount withheld from every paycheck. It is then held in a fund from which you are reimbursed.
There are two disadvantages to that type of program:
(a)You have to determine a year in advance how much you want withheld. Unlike the MERP, there is no way to pay for an unexpected medical cost, and
(b)You are limited by law to the amount that can be withheld each year. Right now those limits are $3,350 for individuals and $6,750 for families with a Health Savings Account.