With 2018 tax reform, we have received more and more questions- why shouldn’t I switch to a Corporation? In most cases the answer is simple – it’s not many situations where double taxation is advantageous.
C Corp basics
C Corps have many unique properties. First, they are the most complex form of business. They require the most effort to set up and maintain each year. Because C Corps have been around so long, the laws regarding their operations and liability protection are well established. C Corps are owned by shareholders who, in most cases, cannot be held liable for the actions of the corporation.
C Corp taxation
When it comes to taxes, the C Corp pays income tax on its income. C Corps have much more generous rules regarding employee benefits for shareholders. Many times, officers of C Corps can have benefit packages that significantly outweigh their actual salary. Many of these benefits are either limited or not available to owners of other business types. C Corps do have some drawbacks though. While figuring its tax amount, it does not get to deduct the amounts paid to shareholder as dividends. As an example, if a C Corp has $100,000 in operating profit and then pays out $60,000 in dividends to its shareholders, it is taxed on the full $100,000. That means that corps must be careful to not pay more dividends than they afford since they need to maintain enough cash to stay afloat and cover taxes.
Here is where the pain hits home though for owners of small C Corps. That $60,000 in dividends gets added to their personal tax returns as additional income. So their personal taxable income jumps up along with their tax bill. The term double taxation comes from the fact that both the C Corp and the individuals pay income tax on the dividend income.
Another major drawback to a C Corp happens in years where the business generates a loss. Let’s say you run a C Corp and just had a rough year. You paid yourself just enough of a salary to live on ($50,000), but overall the C Corp lost $200,000. With most business types, you would be able to net those two numbers together to produce a net loss of $150,000 when calculating your personal taxable income. But with a C Corp, the loss gets stuck inside of the C Corp. That means you will still pay tax on your $50,000 salary, but the C Corp’s $200,000 loss does not help you at all. Having a C Corp in a couple of down years can cost tens of thousands of dollars in extra tax.
Who should have a C Corp?
If a C Corp’s income is subject to double taxation, who would ever set one up? The answer is almost always large businesses. It is quite rare that a C Corp is the right answer for a small business or an independent professional. There are cases where it makes sense for a small business, but those are few and far between. Large businesses rely on the C Corp’s structure and ability to sell stock to be able to raise funds. They rely on its proven liability history and its ability to provide benefits to officers. If your net income is over or approaching $1 million per year, 2018’s corporate income tax rate of a flat 21% is low enough that you may want to have a competent tax advisor prepare a comparison of tax structures for you to see if switching to a C Corp makes financial sense.
For everyone else
Unless you have a large company or a specific need for a C Corp, there are many other options that can fit your needs much better (and much cheaper!). LLCs are an incredibly flexible option that allow us to make tweaks to your tax plan as needed. Paired with the proper tax election, an LLC can meet the needs of many small businesses.
How can we help
Selecting the right business entity and taking advantage of every legal tax strategy provides you with a competitive edge in the marketplace. If you aren’t 100% sure you have the right structure in place, or if you aren’t sure you are taking advantage of your structure to the fullest, please contact us. We have competent professionals who can guide you through the process and make sure you aren’t missing opportunities that your competitors are taking.