Why Be a C? C Corporation that is

Tom Crouser July 31, 2012 Comments Off on Why Be a C? C Corporation that is

Most small businesses are either proprietorships, partnerships, Limited Liability Companies or S Corporations. Some select C Corporations and I wonder why. Here are my thoughts on the subject.

Why Be a C? Why be a C corporation, that is? That’s my question. The answer I most often hear is “because my accountant said I would pay less in taxes.” While no one is thrilled about paying taxes, I want you to go beyond that answer to understand why you may pay fewer taxes. I also want you to review your decision yearly because circumstances change.

The following will sound a lot like tax advice – it’s not. My advice is to seek a qualified tax professional and, further, to actively participate with the decisions that are made. That’s the same thing you would do with your doctor if you had a dread disease. So, the following is not meant to be tax advice – it is meant to encourage you to participate with your tax professional in your financial decisions.

This is not to say that there are not legitimate reasons for being a C – it is to say that most companies we see are S corps or LLCs. And, for that many folks of our size and type to be S corps, well, I think that if you are not, you need to know why you aren’t.

Let’s first understand the basic differences between the C corporation (C corp.) and S corporation (S corp.). Their names were each taken from the section of the federal tax code under which they were created. (There’s also a T corporation – but that’s rarely used.)

On the surface, it’s almost a no-brainer. The C corp. will pay two levels of income tax – first a corporate income tax on earnings and then the stockholders pay personal income tax when they take the money out in either wages or dividends. The S corp. generally passes its taxable income or loss directly through to the owner, avoiding the double taxation.

Specifically, with a C corp., the first $50,000 of net income is taxed at 15%, the next $25,000 at 25%, the next $25,000 at 34%, and the rates go up from there. Then any wages or dividends paid to the owners are taxed again at the personal rate – 10% (very low income) to 35% (2011 rates). Therefore any wages or dividends flowing out to the owner will be taxed at a higher rate within a C corp. than an “S” corp. because of the combined corporate plus personal rates. And to add insult to injury, dividends are not tax deductible to the corporation; instead they are a distribution.

Contrast that to an S corp., which is also known as a “pass through” entity. The overall effect is the corporation is taxed similar to a partnership. While you file a corporate tax return, the income passes through to the personal tax returns of the owners to be taxed at the personal rate and avoiding the corporate tax add-on.

So why wouldn’t everyone want to be an S corp.? Well, for one, it’s not always available – for instance you can’t be within New Hampshire or Washington, DC and possibly other states. If you are in that situation, well, read no more. The rest doesn’t apply to you. Additionally, one reason not to be an S corp. might be your state tax situation. The way states tax an S corp. varies widely – from favorable to very unfavorable so state taxes are a key.

Start-Up

If you were without a lot of outside earnings and starting a new corporation, then a C corp. might be right because you would expect to have losses in the early years. An advantage to the C corp. is that these losses can be accumulated and offset income in later years. If you were an S corp. in this scenario, the losses would pass to the owner who wouldn’t be able to offset them against other income (unless there was income outside the business) and they would be lost (even bad things sometimes have value).

And, it is reasoned, once earnings do begin – then the corporation could be switched to an S corp. with one level of income taxes. Problem I find most commonly here is that lots of folks elect the C corp. scenario and never review it again.

You are not an S corporation until you apply and receive an acceptance letter by the IRS (no exceptions). To make the election you have to file within 2½ months before you start the business or 2½ months after the tax year for an ongoing corporation. If you miss the date you have to wait a year. The election is effective until terminated. Also an S corporation that was once a C corporation may be subject to one or more of three separate taxes (e.g., the “built-in gains” tax). This rule is an exception to the general rule that S corporations are not subject to tax.

Okay, but there is another start-up scenario. Let’s say one made a lot of money in a printing company and started a pizza place where losses were expected the first few years. Well, here’s a good reason to start as an S corp. since the losses in the pizza business would pass through to the owners and be offset against earnings from printing.

Note that losses taken cannot exceed your basis in the corporation – original capital plus income less losses – and can also be affected by loans and other transactions.

In this case, one would start as an S and remain an S, at least through the early through middle-aged years of the business.

Growth

Many reason that growing companies don’t take money out of the business – instead they allow the money to be taxed at the lower corporate levels and then reinvest the money into plant and equipment to expand. So, the theory goes, remain a C corp., pay the one lower corporate income tax and then reinvest the earnings into plant and equipment. That’s what many advise and it could be a great strategy.

But, often it is bad execution of a good theory. I don’t see it being done this way. We take out the money as salary, dividends or jacked-up rent and then borrow money based on our increased earnings to pay for expansion accomplishing both aims – taking more money out plus expansion – at least until we crash. Rarely does smaller business self-finance capital expenditures although we should.

Some professionals advise to remain a C corp. and retain the earnings because you pay a lower tax rate. A situation in Montana is an extreme example of this rationale. Our friend “hated to pay taxes.” His accountant hated it also. So, he remained a C corp. so his tax rate would be lower and not take the money out of the corporation. Three problems with this theory; first, just pilling up the money within a corporation (above and beyond current ratio needs) and not doing anything with it for the business or the family doesn’t do either the business or the family much good. It is a poor stewardship of assets.

Second problem is that if there is not a valid reason to retain earnings the IRS can treat it as a failure to distribute to the stockholders and could result in interest, penalties, and legal action to distribute in order to tax the retained earnings as dividends. Takes a lot to trigger this but it can be done.

Third problem, and what I see most often, is at some point we always take the money out. Maybe not this year, but eventually we do. Our Montana friend is facing this reality as he now contemplates selling the business. He complains that he can’t sell the business because he would have too much tax to pay.

Montana can certainly minimize his immediate cash outlay on taxes, but he can’t avoid them all together unless he doesn’t make money. Let’s not get carried away here. Paying income taxes is a good thing. It shows you make more than you spend. Paying excessive income taxes as Montana ends up doing is the bad thing.

Taking Over the World

If you were building up a war chest to take over the world, then properly done, a C corp. would be a good vehicle. You could earn money, pay only the corporate income tax, which would be lower than the personal amount, and have more money left over to buy other companies. Unfortunately, I’ve seen this happen only once. My opinion: more good theory, bad practice. Why? This only works IF you keep the money in the business and do not intent to take it out. I rarely run into owners who really do this.

Transitioning

Many times a C corp. is a good device for business transitions and this is where we see it used the most. Generally if mom and pop own 99 shares and junior owns 1, then the stock of mom and pop could be repurchased over time reducing it to 0 shares for mom and pop and 1 share for junior – or 100% of the corporation. Don’t do this without proper legal and tax advice.

Why Not to be an S Corporation

Here are some other reasons people advise not to be an S corp. with my comments.

+ Only eligible shareholders can receive S corp. stock and cannot have more than 75 shareholders. No problem in our businesses. Never ran into a small business with 10 stockholders, let alone 75 and the stock ownership thing applies mainly to trusts, pension plans, etc. – not to us normal folks. Worry about this during transition when you are rich and famous.

+ Estate planning is more complicated with an S corp. Don’t do it that way. Select, train and install your successor in your lifetime as Dr. León Danco says and transfer the business to the next generation when you retire, not when you die.

+ Fewer tax-free fringe benefits are available for shareholder-employees of S corp. than C’s.
And there is not full deductibility of personal health insurance premiums (although this may be changing).
I have never seen this fact weigh heavily enough to make the difference in corporate status.

+ Medical dental reimbursement plan for pre-tax reimbursement of non-covered medical expenses are not available in S corp. Other benefits can also be structured this way including relevant education costs, group term life ($50,000), and employer-provided vehicles. This could be a reason for being a C corp. given a special situation. The Medical Reimbursement Plan allows the company to pay all of the employees’ medical expenses and are 100% tax deductible and not income for the employees. Problem is it must be applied to all employees. This might end up costing the business owner more than if they paid for their own family’s medical expenses with after tax dollars.

+ Deductible life insurance premium in C corp. Limited to $50,000 term that’s not available to S corp. Haven’t seen this as being a factor either.

+ Deductibility of key person disability insurance premiums are not available. I wouldn’t want to deduct in the first place since if you do, then benefits are taxable income to the individual shareholder. Better to pay taxes when you are healthy than when you are disabled.

+ Greater deductibility of retirement plan contributions, up to the lesser of $40,000 or 100% of income (SIMPLE plans limited to $7,000, and other S corporation retirement plans (SARSEPs and SEP-IRAs) limited to the lesser of $11,000 or 15%). (Note: rules may have changed on this.) Applies, but this is where the calculator really has to come out – and remember these benefits change frequently. All the more reason to have your status reviewed annually.

+ Aggressive tax planning opportunities for those with consistent annual surplus earnings of $100,000 or more (this amount includes retirement contributions). Okay, here would be a reason I would buy. Unfortunately it happens to few of the businesses that I see who are C corps.

+ Non-resident aliens cannot own S corp. shares. I have never seen this affect anyone although I am sure that somewhere it must.

+ Employee stock ownership plans are not available to S corporations; ESOPs can be used after 1997, but some of their tax advantages are not available to S corporations. Well, I would never advise you do this in the first place with our sizes of businesses.

+ Taxes are paid on income regardless of whether profit is distributed to the owners. True, but every S corporation I have ever seen distributes a dividend to cover the owners’ taxes. More often, someone remains a C corp. and pays income taxes on their salary while the corporation doesn’t make money. That’s the situation I see most often.

+ Division of wages and profits in S corp. causes audits. Yes, but same can be said of C corps. In an S corp., red flags are raised if you pay yourself a salary of $10,000 and have dividends of $100,000 for instance. This is a favorite audit area for the IRS and is says you are avoiding social security taxes, etc. So, just pay yourself a fair wage for the job you do and take the rest out in dividends. The reverse happens in C corps. Taxman says the salary is too high making corporate net income zero and thus avoiding corporate income taxes. Can’t avoid the possible audit either way, so pay yourself a fair salary and take the rest out in dividends (leaving enough working capital so the business can survive).

If you dream of turning your business into a big company, the C corporation structure is the best way to attract investors. Also if you are attracting institutional investors, the C corp. doesn’t saddle tax-exempt inventors with taxable pass-through profits. If you are truly worried about this in your business, then you’re reading the wrong advice column. I just don’t see this in small business. I say worry about the C structure when it is apparent that it will happen.

Tax Breaks: Sometime special tax incentives are available for C corporations. In some states being in a development zone will qualify a company for tax breaks but only if they are C corps. Good reason, but one must make sure that the tax breaks outweigh the cost of the C corporation. Your professional accountant should be reviewing this on a yearly basis with you.

Conclusion

I’m not saying you shouldn’t be a C corp. I am not even claiming that everything in this article is factual – although I believe it is. I am saying that there should be a specific reason for you to be a C corp. or an S corp. or an LLC and those reasons change over time.

And it is you, who should know the reason why and be able to articulate it in general terms. Otherwise, you may just be doing something this year just like it was done last year, just like we did the year before that. So review your status every year because it changes every year

Finally, as a post script, S corp. profits are not subject to self-employment tax, so there is a potential tax savings over doing business as a sole proprietor. Any salary paid to owners will be subject to social security tax but profits that pass through are viewed more as a return on investment and are not subject to social security tax (a.k.a. self-employment tax). But that’s a subject you need to chat with your professional accountant about.

Hope this helps.

Tom Crouser

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