The C Corporation versus the S Corporation

Why Would Anyone Use a C-Corporation?

John is a real estate investor who is wholesaling and flipping properties.  He is in the beginning stages of his business and some attorney says to create something called a “C-Corporation” for his business.  He forms the business and all is well until he talks to his accountant who cries “Why would anyone use a C-Corporation?”, “You should have been set-up as an S-Corporation”.

Sound familiar?

John isn’t feeling so great after talking to his accountant.  He heard terms like “double tax” and got sick to his stomach.  He does not know what to do.  His plight is not uncommon and comes from a fundamental misunderstanding of differences between S-corporations and C-corporations that permeates the accounting profession.  My personal belief is that most accountants are simply used to repeating the refrain “double tax “ that they ignore doing any sort of calculations.  Allow me to explain.

LLCs and standard corporations may elect to be treated as S-corporations for federal income tax purposes.  In English, all corporations are C-corporations unless an “S” election is made.  LLCs can choose to be taxed as either.  For our purposes, we will focus solely on the two tax types – “C” vs. “S”

As I stated, all corporations start off as “C” corporations for tax purposes.  This simply means that the corporation pays federal income tax on its profits at the corporate tax rates.  For example, the corporate tax rate on the first $50,000 of income is 15%.  The “C” corporation would pay tax on that portion and then make a decision to either retain those profits or pay them out to its owners (called shareholders).  When a “C” corporation pays out profits, it is called a dividend.  This is where the double tax comes in – the recipient pays taxes on dividends at a rate dependent on that recipient (for individuals, it is taxed at long-term capital gains).  

If an “S” election is made, the corporation’s income will flow down to the shareholders to be taxed at their personal income tax level.   This will be passed down to the shareholders in proportion to their ownership via a form called a K-1.  Regardless of whether the income is distributed to the shareholder, the shareholder will be responsible for the tax.  The good news is that the income that passes down to the shareholders is not subject to FICA, unemployment, workers compensation, or similar employment-related expenses.   This is why accountants tend to gravitate towards S-corporations; however, as you will see, it is too simplistic.  

Here is an example of the C vs. S Corporation:

John lives in Nevada – makes $100,000 a year in his job and his wife makes $50,000 in her job.  They flipped three houses, netting $25,000 each.  They had $20,000 in classes and coaching during the year, cell phone expenses of $3,000, uncovered medical expenses and co-pays of $2,500,  $2,500 medical deductibles and $2,000 of dental co-pays and expenses.  Now let’s do the math and compare an “S” versus a “C” corporation under this scenario:

“S” “C”
Income

$  75,000

$  75,000

Allowed Expenses

$  23,000

$  30,000

Corporate Income

$  45,000

Salary to Shareholder

$  18,000

Flow-Through Income

$  34,000

Estimated Total Tax

$  17,080

$    6,750

 

The net difference is over $10,000 in favor of the C-corporation.  This assumes the profits remained in the company to continue operations.  Of course, if the profits had been distributed and the “double tax” triggered, the total tax would have still been $12,488 – almost $5,000 less than the S-corporation.  

This is just an illustration, but hopefully, you get the point.

What the CPA or Tax Professional does not tell you:

S-corporation have to pay salaries to shareholders (the rule of thumb is 1/3 of net income – the rule is a reasonable salary) before profits flow down.  This salary is subject to federal withholdings, employment, and FICA taxes.     

S-corporations do not have the same fringe benefits as C-corporations, so medical, dental, vision and related benefits are taxable to shareholders.

The profits that flow down to shareholders flow down into the shareholders’ top brackets.  

There are restrictions on who can own S-corporations (individuals, US residents, certain trusts).

Complete Transparency:

Starting with a C-corporation does not mean the company will always be a C-corporation.  You have the option on an annual basis to make an S-election and convert to an S-corporation.  There are also times when it will make sense right out of the gate to be an S-corporation (such as certain professional activities that are taxed at a higher rate if conducted within a C-corporation or an existing sole proprietorship where the owner does not have substantial other income), but those tend to be fairly obvious when running calculations.  

The takeaway is to beware of professionals that make blanket assertions without calculations.  There are nuances to all situations and rarely are there one-size-fits-all solutions, so making an election as important as an “S” election is not something that should be done automatically without careful consideration.  If you hear someone make the knee-jerk reaction “C-corporations are bad because of the double tax”, just take it as an opportunity to have them crunch some numbers and learn for themselves what is obvious to many of us in the legal and tax field:  C-corporation can be very advantageous.