When deciding what structure will work best for your business, it’s important to consider the tax implications. Recent tax law changes should be considered as you examine your options. For a variety of reasons, forming a c-corporation may prove the most advantageous.
Top 9 Reasons to form a C-Corporation
- Lower Corporate Tax Rate and No Alternative Minimum Tax
- Limited Liability
- Multiple Payment Options for Owners and Employees
- Stock Variety and Ownership Options
- Continued Company Existence
- Carry Losses Backwards and Forward
- Many Business Deductions
- Qualified Small Business Stock (QSBS)
- Rollovers as Business Startups (ROBS)
A corporation is a legal entity separate from its owners which provides many benefits. Anyone who goes into business can choose to form a variety of business entities, such as a C Corporation, S Corporation, Limited Liability Company (LLC), Sole Proprietorship and Partnership.
Lower Corporate Tax Rate and No Alternative Minimum Tax
A C-corporation gets its name from Subchapter C of the Internal Revenue Code (IRC) and it is substantially different from the other business entity types that may be considered. One key difference is that C-corps are subject to a corporate tax on business income. Then, when the C corp pays out profits to owners, they face taxation again– which leads to double taxation for C corp profits. In contrast, other business types are considered “pass-through” businesses in which profits are passed to the owners and taxed only on their personal income taxes. Certain business types like sole proprietors may also have to pay self-employment tax. To complicate matters, LLCs can elect to be taxed as C corps and corporations can elect to be taxed as pass-through businesses in certain situations.
The recently enacted Tax Cuts and Jobs Act made significant changes to the tax code, including permanently lowering the corporate tax rate from 35% to 21%. In comparison, pass-through businesses may only receive a 20% deduction on qualified business income for certain business types. These pass-through businesses will only be able to claim this deduction for the next few years, whereas the 21% tax rate for C Corps is permanent. In addition to this benefit, corporations no longer have to face the Alternative Minimum Tax (AMT), a separate way of calculating taxes that carried hefty penalties. The AMT is still applicable to personal income. After the sunset of the 20% deduction for pass-through businesses, the value of C-corp taxation will increase in comparison.
Limited Liability
One of the key benefits of a C-corp is that it is considered a separate legal entity from the owners. This means the owners cannot usually be held personally liable for any business debt or other liability issues, such as when being sued. Other types of business entities, such as S-corps and Limited Liability Companies (LLCs), can also offset liability issues from owners and shareholders– but sole proprietors and implicated partners in a partnership can be held personally liable. This means lawyers can go after their personal assets to settle debts and liability lawsuits. In rare cases of gross negligence or unethical behavior, courts have attempted to pierce the corporate veil and go after the personal assets of business managers and owners.
Multiple Payment Options for Owners and Employees
The double taxation facing C-corps may at first seem like a disadvantage, but once you factor in the additional benefits it may be worth considering this type of structure for your business. C-corps issue stock to corporate shareholders who in essence own the company depending on the type of stock issued. For example, some stocks give shareholder voting rights while others may not.
In addition to the lowered corporate tax rate, C-corps can utilize a variety of methods to disburse funds to shareholders and owners which may lower or avoid the second layer of taxation. For example, qualified dividends to shareholders may be taxed at long-term capital gains rates which are lower than regular income tax rates. Non-qualified dividends are taxed as ordinary income. To be a qualified dividend depends on stock type as well as how long the shares are held. It is also important to point out that income from investments may be subject to the additional Net Investment Income Tax of 3.8%, which applies to those taxpayers with a modified AGI over $200,000 for single filers and $125,000 for those married and filing separately.
Instead of (or in addition to) paying out dividends which shareholders must pay taxes on, many C-corps can also reinvest profits into the company to increase the stock value. This benefits stockholders who can then sell stock at a higher price when they want, but pay tax on the capital gains. A critical decision for business owners is what decisions to pass on to the shareholder who will have to pay income taxes on certain business profits. Some companies even allow stockholders to reinvest their dividends back into the company on their own to gain more shares. C-corps can also offer a variety of benefits to owners through increased salaries and wages, and payouts of cash, property, or services which may be tax deductible as well. Each method of passing value to stockholders carries a tax implication, which is why choosing the right business entity depends on your business and desired investment options.
Stock Variety and Ownership Options
While an S-corp avoids double taxation entirely, it is very limited by the IRS on the type of stock it can issue, as well as the number of shareholders allowed. In contrast, a C-corp can offer a variety of stocks, such as preferred stocks, and has no limits on stockholders. C-corps also allow for non-resident aliens to own stock, a benefit not allowed for S-corps. While corporations usually face more regulations than other business types, those C corps worth higher values and with over 500 shareholders must register with the Securities and Exchange Commission (SEC), which means increased oversight. C corp stocks are usually the preferred choice for many investors because of these reasons.
C-corps can be owned by other companies, and can own other companies except for S-corps. A C-corp may also be a member of an LLC that is taxed as a pass-through business. S-corp stocks and ownership in other business types carry increased risk and taxation issues. Therefore, it may be easier to secure venture capital funding for startup businesses as a C-corp. However, due to the complex nature of taxes and related issues, it is always a good idea to consult a tax advisor on the specifics of your situation.
C corporations start when a company files articles of incorporation (also called a certificate of incorporation) and require stockholders to appoint a board of directors to make business decisions. A corporation also must write bylaws and follow state and federal regulations. A corporation must also choose a fiscal year that may or may not coincide with the calendar year. In addition, corporations that expect to owe more than $500 in taxes during a given tax year must pay estimated taxes quarterly.
Continued Company Existence
Another benefit of C corporations is that they exist separately from the owners, which means they will continue after the owners decide to sell the business. This is another reason my investors may choose a profitable C-corp, which may offer a more stable choice over longer periods of time and at higher rates than typical Treasury Bonds or other investment options. It is also possible to change business structures so a sole proprietor can restructure as a c corporation or other business type and vice versa. An important note is that there may be a delay before a company may change types again after an initial change, and there are tax implications.
Carry Losses Backwards and Forward
When first starting out, many businesses may not realize a profit in their beginning or subsequent years. A benefit of C-corps is that the company can deduct Net Operating Losses (NOL) against both previous and future taxes which can impact their current year tax return. There are many restrictions and rules to consider with this method, so consulting with a tax lawyer is very advisable. Claiming an NOL against a previous year will require recalculating that previous year’s taxes but may result in an additional refund.
Generally, a C-corp may be able to apply an NOL up to 2-3 years previously and up to 20 years forward if there is any excess. This benefit provides startup companies with an additional boost not available to pass-through businesses. In contrast, companies with pass-through taxation cannot claim losses, but individual owners may with limitations. Where partnerships and other pass-through businesses do not face corporate taxation, the business owners must claim their profits on personal tax returns. The 20% deduction for some pass-through taxation will only be available for the next few years.
Many Business Deductions
Along with deducting losses, there are a wide range of business deductions available exclusively to C corps as well as those available to other entity types. For example, a C-corp might be able to deduct the employer’s share of payroll taxes, medical premiums, charitable contributions, and even salaries and other business expenses. There are also depreciation deductions available under the new tax reform as well. To take advantage of these deductions means that a C corporation can offer increased fringe benefits for owners and employees such as better health care plans, retirement accounts, and company reimbursements for travel. It is advisable to seek legal counsel on the different business options available to a C-corp.
Qualified Small Business Stock (QSBS)
A major benefit for investors looking for tax-free investments is the qualified small business stock (QSBS). Original issue investors of a startup may be able to exclude capital gains from any taxation in later years, subject to limitations and regulations. This may also be used as incentives for employees during those lean start-up years experienced by many new companies. For start-ups looking to incorporate, this may be a valid option to consider. Due to the high investment amount this method may also help reduce the number of corporation shareholders needed to get started.
Rollovers as Business Startups (ROBS)
Another benefit for those considering starting a C-corp is the Rollovers as Business Startups (ROBS). This is a special move which allows an owner to use certain retirement accounts, like a 401(k), to buy stock in the C-corp being created. This rollover is tax-free and may be used to fund the company start-up. It may especially be helpful for some small business owners looking for start-up capital and hoping to avoid debts.
Key Takeaways
When it comes to starting a business, there are many available entity structures, each with unique advantages and disadvantages. The best choice depends on your unique investment needs or business goals. One of the main issues with a C corporation is that it faces double taxation where the company is taxed on profits and then the stockholders are taxed on their personal income from the company.
Despite this, many choose to invest in C-corps because of the many other benefits they provide. A major benefit is that C corps are considered separate legal entities and give liability protection to investors. There are also many ways for a corporation to pass profits on to owners, each with different tax implications. These can include dividends, cash or property distributions, debt repayments, and tax-free fringe benefits. C-corporation tax rates are also very beneficial right now. C-corps allow for different types of stocks in unlimited numbers not available to other entities. In addition to these stock benefits, C-corps have a variety of ownership options and can even allow non-U.S. residents to invest.
Another benefit specific to C corporations is the ability to carry losses either forward or backward on other tax years. There are also a variety of business deductions that a C corp can claim, such as payroll taxes, medical premiums, charitable donations, depreciation, and so on. This is by no means an exhaustive list. Please consult with a tax advisor to find out more.
For those looking to start a business, there are two exciting options to consider. Offer Qualified Small Business Stocks (QSBS) can entice investors early with the possibility of tax-free gains under certain conditions. These can also be used to “pay” employees, which can allow the company to reinvest money instead of paying wages initially. There is also the possibility of using retirement accounts to fund a startup business. This method, called the Rollovers as Business Startups (ROBS), may allow one to buy company stock with retirement funds at a tax-free rate and set them up in your company-sponsored retirement account.
Choosing a corporation status is a very important choice that will impact future business. Due to the complex nature of taxes and their impact on your unique situation, the best way to take advantage of the benefits available is to consult with a legal tax professional such as Anderson Advisors. Determining the best business entity is just the start of your company’s journey, and it’s important to make that first step count.
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