Starting a business is a big decision. You have to weigh potential benefits against what you know you will be giving up. For most people, starting a business is a life-altering decision. Once the decision is made, the choices only multiply from there. You will have to consider choice of entity, sources of capital, fringe benefits, ownership structure, liability protection, location and taxes. For many small-business owners, the choice of entity and tax filing status often leads to the formation of an S-corporation. Most taxpayers have been advised for quite some time that the primary difference between a C-corporation and an S-corporation is how (or how often) the business is taxed. It is true that income from a C-corporation can be taxed twice, first on its net income at its corporate tax rate, then at the shareholder level when distributions are made as dividends. Conversely, an S-corporation is only taxed at the shareholder level at the individual income rates.
So, being taxed once is better than being taxed twice, right? The best answer to that is “sometimes.” With the maximum individual income tax rate increased to 39.6 percent after the passage of the American Taxpayer Relief Act of 2012, selecting between filing as a C-corporation and an S-corporation has become more complicated. In fact, given the right set of circumstances, C-corporations can actually help minimize overall income taxes from some businesses.
Beyond taxes, C-corporations also offer significantly more flexibility when it comes to stock and ownership options, investment and funding alternatives and more. Other potential benefits include the treatment of fringe benefits, a reduced rate of capital gains taxation on the sale of qualified small-business stock, easier stock transfers and lower tax rates on the first $100,000 of net income.
Which entity will result in lower taxes?
In larger part, the answer to this question depends on the specific situation and how a business plans to utilize any income. The most important thing to know is that a default answer of “the S-corporation will pay lower taxes” is not necessarily always correct. How can the answer become murky? And when might a C-corporation pay less?
Small-businesses taxed as C-corporations receive favorable treatment if taxable income is reduced to $75,000 or less. This first $50,000 is taxed at 15 percent, and the next $25,000 is taxed at 25 percent. An individual with flow-through income from an S-corporation or partnership who is in the highest income tax bracket pays a rate of 39.6 percent. If owners take W-2 income or have other investments or income that push them into higher tax brackets, they may actually be able to reduce their effective tax rate on some income if their operating business is a C-corporation and the profits are retained in the business for working capital. With a C-corporation, double taxation only occurs when profits are distributed as dividends. Leaving profit in the company can mean paying only the corporate tax rate, which in the scenario above would be far less than the individual rate.
Many advisors correctly warn of “double taxation” with a C-corporation. Businesses that plan to distribute most of their earnings to the owners or that plan to ultimately sell the company via an asset sale must certainly consider the impact of double taxation. For these businesses, an S-corporation may very well provide significant tax savings. Still, double taxation can be mitigated through a sale of stock, as opposed to a sale of the company’s assets. A C-corporation could also subsequently elect to become an S-corporation. After five or ten years as an S-corporation (depending on the current statute on built in gains), the corporation can sell the assets and not worry about double taxation.
Below are two examples which demonstrate how C-corporations and S-corporations may be taxed. This example assumes that the individual is in the highest tax bracket and generates additional business income of $65,000 through their company:
|Cash retained as working capital||$53,750||$39,260||$39,260|
Now assume the same facts as above, but instead of being retained as working capital, the leftover cash is paid out as a dividend.
|Tax on business income||$11,250||$25,750*||$25,740*|
|Cash paid as dividend/distribution||$53,750||$39,250||$39,250|
|Owner’s income tax on dividend||$12,793**||—||—|
|Net cash to owner||$40,957||$39,250||$39,250|
*Paid at the owner level at 39.6 percent on the income passed through from the entity.
**Taxpayer assumed to be subject to the 3.8 percent net investment income tax on this income in addition to the 20 percent tax rate on qualified dividends.
The example above is not meant to demonstrate that a C-corporation will necessarily result in greater overall retained earnings or net cash to owners. In many cases, an S-corporation will result in a lower tax liability. It is simply worth noting that the tax analysis should not be overly simplified, and that in specific circumstances a C-corporation could actually result in lower taxes.
“Fringe benefits” of a C-corporation
In addition to situation specific federal income tax savings, C-corporations also can receive tax benefits on fringe benefits such as health insurance premiums for owners paid by the C-corporation. Additionally, a C-corporation can fully deduct long-term care and disability insurance premiums without any additional income reported to the owners. S-corporation owners would have to pick up these benefits as gross income for the S-corporation to fully deduct these premiums. Lastly, where most owners of a C-corporation are also employees, a medical reimbursement plan under Sec. 105(b) allows the C-corporation to cover all medical expenses not paid for by the insurance plan. As long as the plan is nondiscriminatory, the reimbursements are not taxable to the employees.
Ownership and capital requirements
In addition to the tax ramifications of selecting a C-corporation versus an S-corporation, limitations placed on companies that elect S-corporation status can also reduce ownership and capital options. The S-corporation election was created as a filing option for small-businesses. An S-corporation can only include U.S. citizens and resident aliens as shareholders and must have no more than 100 shareholders. An S-corporation also does not have the ability to issue different classes of stock. If a company has a large number of shareholders, may seek outside funding or has foreign ownership, a C-corporation may be the best or even the only alternative available. Companies that may seek private equity investments, want to expand quickly through equity financing, have large numbers of shareholders, need multiple stock classes or are planning a public offering are usually best filing as C-corporations.
Fewer restrictions apply to transfers of C-corporation stock. Businesses that want to offer the company stock publicly will need a C-corporation structure. S-corporations also typically have buy-sell agreements that restrict the transfer of the business to others, unless the transfer is approved by other shareholders or members.
How should a company decide if C-corporation or S-corporation status is best for them?
While S-corporations have generally been considered preferable for smaller businesses, new tax rates and laws can complicate the discussion, requiring more in-depth analysis. Business owners should consider the amount of income that the business will generate, whether income is going to be left in the business or taken out, and current and future ownership and financing needs.
Any filing election decision, whether at the time of formation or later in the life of a company, should be made based on the current and future needs and conditions of the business after a discussion with a qualified advisor.
Taxpayers should also keep their endgame in mind when selecting or changing their entity structure or filing election. Changes in tax rates, along with growing popularity of obtaining capital from outside sources such as crowdfunding, have helped C-corporations gain popularity over the last couple of years. While S-corporations are still the popular and often wise selection for many businesses, C-corporations can work well under the appropriate circumstances.
Deciding on filing as a C-corporation or an S-corporation is an important decision for any company. Many factors – past, current and future should be considered before making or changing an election. If you are making an initial election or considering changing your filing status, we can help. Call our office today to set up a consultation.