Everybody knows that small businesses that are C corporations are subject to double taxation, but S corporations and limited liability companies (LLCs) taxed as partnerships or disregarded entities are only subject to tax at one level. Yet, according to a study released earlier this year by the U.S. Treasury Department, 1.56 million small businesses are C corporations.
Given the apparent tax disadvantage of the C corporation form, the question is why do so many small businesses choose to do business as C corporations. While poor or non-existent tax advice may be the reason some of these businesses are C corporations, there are legitimate reasons for a smaller business to choose to operate under subchapter C.
Corporations are typically taxed at a lower rate than individuals. A C corporation determines its annual income tax liability by applying a progressive rate of tax to its taxable income, just like an individual, but the brackets are typically higher.
The corporate income tax rates consist of four brackets:
* The first $50,000 is subject to 15-percent tax.
* $50,001-$75,000 of income is subject to a 25-percent marginal rate.
* $75,000-$10 million in income is subject to a 34-percent rate.
* Any amounts over $10 million are subject to tax at a 35-percent rate.
The 34-percent rate is phased out by an additional five-percent rate on income between $100,000 and $335,000. The 35-percent rate is phased out by an additional three-percent rate on income over $15 million. The additional tax under the three-percent add-on is limited to $100,000.
The effect of the added rates is to impose a flat 35-percent rate on corporations whose taxable income exceeds $18.33 million and a flat 34-percent rate on corporations whose taxable income exceeds $335,000, but is $10 million or less.
Income tax is imposed on individuals for tax years beginning in 2011 at the following rates and bracket amounts:
* For married taxpayers filing jointly and surviving spouses, the maximum taxable income for the 10% tax bracket is $17,000; for the 15% bracket, $69,000; for the 25% bracket, $139,350; for the 28% bracket, $212,300; and for the 33% bracket, $379,150. Amounts over $379,150 are taxed at 35%.
* For single filers (other than surviving spouses and heads of households), the maximum taxable income for the 10% bracket is $8,500; for the 15% bracket, $34,500; for the 25% bracket, $83,600; for the 28% bracket, $174,400, and for the 33% bracket, $379,150. Amounts over $379,150 are taxed at 35%.
Compared head to head, the two tax structures are only somewhat different. Corporate tax rates for amounts lower than $379,150 generally compare unfavorably to those for joint filers, but may compare favorably or unfavorably for single individual taxpayers. For example, $50,000 of corporate taxable income would normally be subject to $7,500 of tax; however a single individual with $50,000 in taxable income will be subject to $8,625 in tax, $1,125 more. Amounts greater than $379,150 in corporate income will be taxed at a slightly lower rate (34 percent vs. 35 percent).
An apples-to-apples comparison may be difficult here because corporations do not receive tax benefits available to individuals, such as personal exemptions, that reduce individual taxable income.
However, the real advantage comes in when the corporation's shareholders have significant income from other sources. Since the top individual rates are 33 and 35 percent, any income from a business operated in a passthrough entity will be effectively taxed at those rates. In comparison, the rates on the income of corporations with less than $75,000 are either 15 or 25 percent.
However, that still leaves the owner with the problem of the second level of tax. First, though, note that the rates for qualified dividend income are already low, at 15 percent for upper-bracket taxpayers. Also, shareholders may avoid the second level of tax altogether by simply leaving the profits in the corporation (although, the accumulated earnings tax, see below, should be taken into consideration).
Leaving profits in the business is obviously a more viable strategy for taxpayers with other sources of income.
As an alternative to taking earnings out of the business as dividends, C corporation owners may take them as compensation. Compensation is a deductible expense that will reduce corporate income, but is subject to FICA taxes. Before 2011 and in 2012, FICA taxes are imposed 7.65 percent on each of the corporation and the shareholder-employee. For 2011 only, the amount is reduced to 5.65 percent on the employees' portion, but remains at 7.65 percent on the employers' portion. For payments after December 31, 2012, an additional 0.9-percent surcharge is imposed on the wages of high-income individuals as part of the employee's share. Dividends are not subject to FICA tax.
In comparison, sole proprietors and individual owners of disregarded entities, as well as individual general partners and members of limited liability companies (LLCs) taxed as partnerships, are generally subject to self-employment (SECA) tax at rates equal to the FICA taxes imposed on wages. There is no way to avoid SECA taxes on sole proprietor, disregarded entity, or partnership income by paying dividends.
The payroll tax rules for S corporations are a hybrid of the C corporation and partnership/disregarded entity rules. Wages paid by an S corporation to its employees are subject to FICA taxes; however, S corporation income and distributions are not.
The temptation to avoid FICA altogether by making distributions but paying no wages to S corporation employee-shareholders should be avoided. The IRS may reclassify amounts of distributions as wages unless the S corporation pays its employee-shareholders reasonable compensation for their services.
Another advantage offered by C corporations is the ability to offer tax-free health benefits to their employees. Health benefits provided to partners and 2-percent shareholders of S corporations are generally included in taxable income. The partner or shareholder receives an offsetting deduction, but the amount is still subject to FICA or SECA tax.
Accumulated Earnings Tax
A major problem with C corporations, and a factor that vitiates the tax advantages of keeping profits in the corporation, is the accumulated earnings tax. Accumulated earnings tax is imposed on corporations formed or availed of to avoid tax on shareholders by accumulating earnings.
For tax years beginning before 2013, the accumulated earnings tax is equal to 15 percent of accumulated taxable income. For tax years beginning after 2012, the tax is imposed at the highest rate of tax for single individuals. Accumulated taxable income is taxable income, with adjustments, reduced by dividends paid deduction and earnings accumulated for reasonable business needs or minimum credit amount.
Accumulated earnings tax only applies to C corporations and is not an issue for sole proprietorships, disregarded entities, partnerships and S corporations.
Another major disadvantage is the inability to take C corporation income against individual income. High-income individuals who might otherwise like the low rates available on C corporation income will not be able to use losses from the business to shelter their income from other sources.
Even businesses with positive cash flow will often incur tax losses in their first year or two because of accelerated depreciation and generous expensing allowances under Code Sec. 179. One strategy might be to start the business as a partnership or disregarded entity, whose losses would flow through to the individual return, and then convert it to a C corporation when it starts generating taxable income.
In addition to the accumulated earnings tax, two other potential traps exist for small businesses that operate as C corporations: the additional taxes imposed on personal holding companies and personal service corporations.
A personal holding company is subject to additional tax on any undistributed personal holding company income. A corporation is personal holding company if more than 50 percent of its outstanding stock is owned, directly or indirectly, by five or fewer individuals, including organizations treated as individuals, and 60 percent or more of its adjusted ordinary income is personal holding company income. Personal holding company income includes dividends, rents, royalties and other specified types of passive or service income.
The personal holding company tax does not apply to sole proprietorships, partnerships, or S corporations.
A personal service corporation is defined as any corporation in which the principal activity is performance of personal service by the owner-employees. The IRS is authorized to disallow tax benefits, if the principal purpose for forming or availing of a personal service corporation is the avoidance or evasion of federal income tax.
Personal service corporations have several other disadvantages. The normal graduated rate structure of the corporate income tax does not apply to a qualified personal service corporation; instead, the 35-percent rate applies to all personal service corporation income. Moreover, personal service corporations are generally required to use a calendar tax year.
However, if these issues can be addressed or planned around, taxpayers may wish to rethink the supposed tax disadvantages of C corporations. High-income individual taxpayers with a side business generating income rather than losses should especially consider running the business as a C corporation, as the rates imposed on the business's income will be significantly lower.