Update: For expert knowledge about corporate double-taxation and other common concerns from small businesses about corporate entities, check out CPA Answers.
Picking the right business structure is one of the biggest decisions that entrepreneurs make when starting a new small business. While many small businesses start out as sole proprietorships or partnerships, business owners may choose to incorporate their business to protect personal assets from company liabilities, such as lawsuits and debt. That’s when they encounter a real alphabet soup of options: LLCs, S corporations and C corporations. How do you pick which option fits your company best?
With the 2018 tax reform changes now in place, C corporations have stood out as a winner among other business entities, but before we dive into the tax benefits of C corps, let’s take a closer look at how the different types of business entities compare when it comes to taxation.
Pass-Through Business Entities: How Sole Proprietorships, Partnerships, LLCs and S Corporations are Taxed
The biggest differences between business structures emerge clearly around tax time. The majority of small businesses in the U.S. are pass-through entities: sole proprietorships, partnerships, Limited Liability Companies (LLCs) and S corporations (small business corporations governed by Subchapter S of the Internal Revenue Code). This means their profits are ‘passed through’ to the owners and shareholders, who then report business income or losses on their personal tax returns. Pass-through entities are not required to pay corporate taxes.
Under the 2018 tax reform, these entities may be able to qualify for a 20 percent deduction on taxes due for pass-through income. For example, if a small business has $100,000 in income that will be passed through, only $80,000 of that would be taxable under the new tax law.
Non-Pass-Through Business Entities: How C Corporations Are Taxed Under the 2018 Tax Reform
A C corporation (governed by Subchapter C of the tax code) is not a pass-through entity and is completely separate from its owners when it comes to taxes. This is no way means a C corp is tax exempt, but rather, any earnings are taxed at the corporate level, and any dividends distributed to shareholders are also taxed at their personal level. Because of this ‘double taxation’ potential, many small businesses have converted to S corporations in the past to avoid it.
However, there are a bevy of tax benefits available to C corps that can lessen or even prevent double taxation. What’s more, savvy business owners are reconsidering their corporate structure in light of the new tax reform, which significantly reduces the tax burden on C corps. Under the new tax bill, the corporate tax rate decreased from 35 percent down to 21 percent, which is lower than the tax rate for pass-through income. And because of the decrease in most individual tax brackets, even income that is passed-through to individual shareholders will be taxed at a lower rate. Combined, this means there may no longer be a significant tax advantage to filing your business as a pass-through entity.
The Tax Advantages of C Corporations
Beyond the new corporate tax rate, there are many reasons entrepreneurs can benefit from opting for a C corp. Even with the possibility of double taxation, this business structure can actually help entrepreneurs lower their overall tax burden. This traditional structure can serve as an immensely useful tool for shifting income for tax purposes, on top of numerous tax write-offs and advantages in attracting future financing. In fact, many companies use the C corporation structure, regardless of size. Here are ten powerful reasons for choosing to incorporate as a C corp:
1. Minimizing your overall tax burden.
As mentioned earlier, the 2018 tax reform bill was a big win for C corporations. The new corporate tax rate of 21 percent can mean significant tax savings for all C corporations, especially if a business doesn’t regularly make distributions to owners in the form of dividends. If business owners are only taking a salary, that amount is not taxed at the corporate rate — shifting the tax equation further in their favor. Not taking a dividend often makes sense for new or small businesses where the money is being reinvested into growing operations.
2. Carrying profits and losses forward and backward.
Whereas the fiscal year must coincide with the calendar year for LLCs and S corps, C corps enjoy more flexibility in determining their fiscal year. Thus, shareholders can shift income more easily, deciding what year to pay taxes on bonuses and when to take losses, which can substantially reduce tax bills.
3. Accumulating funds for future expansion at a lower tax cost.
The C corporation model allows shareholders to shift income readily and retain earnings within the company for future growth, usually at a lower cost than for pass-through entities. Since profits from S corporations appear on shareholders’ tax returns whether they have taken a distribution or not, owners can get bumped into higher tax brackets even though they plow profits back into the company.
4. Writing off salaries and bonuses.
Shareholders of C corps can serve as salaried employees. While these salaries and bonuses fall subject to payroll taxes and Social Security and Medicare contributions, the corporation can fully deduct its share of payroll taxes. Moreover, the company can pay employees enough so that no taxable profits remain at the end of the fiscal year (within reason, of course; the IRS does check that the salaries correspond to the services that shareholders provide as employees). Shareholders frequently use this option rather than receive dividends, which would indeed be taxed twice.
5. Deducting 100 percent of medical premiums and other fringe benefits.
As long as the company makes fringe benefits equally available to all employees, not just shareholders, there are many hefty tax write-offs possible for a C corp that individual employees also receive tax free: medical reimbursement plans and premiums for health, long-term care and disability insurance. It’s a wash for S corporations; the shareholders deduct medical costs from gross income but have to declare these same fringe benefits as income.
6. Writing off charitable contributions.
C corps are the only kind of corporate entity that can deduct contributions (of not more than 10 percent of taxable income in any given year) to eligible charities as a business expense. You can carry over charitable donations above the limit to the next five tax years, too.
7. Carrying losses over multiple years.
This business structure can take large capital and operating losses, and the IRS does not tend to scrutinize businesses, especially new ones, if they show losses several years running. This is especially important for start-ups that may take substantial losses in the first year but wish to carry them forward to future years.
8. Enjoying fewer ownership restrictions than S corps.
S corporations have numerous rules limiting ownership: no more than 100 shareholders, no non-resident alien owners and no non-individual owners (with few exceptions), for starters. They also may not issue more than one class of stock. When entrepreneurs are seeking equity investors, these limitations may keep their hands tied.
9. Encouraging passive investors.
One much-lauded advantage of S corporations is the ability to pass losses through to individual tax returns. However, this only applies to partners who participate actively in the management of the corporation. Thus, passive investors tend to fare better tax-wise under C corporations.
10. Attracting financing and going public.
Venture capitalists prefer the flexible ownership of the C corp business structure, and some forms of small business financing are only open to C corporations, such as 401(k) business financing (see below). Down the road, a small business enterprise might grow into a very big one, large enough to attract funding as a publicly traded company on a national stock exchange, in which case it must be a C corp as well.
C Corporations and 401(k) Business Financing
One of the less-often talked about, yet financially significant advantages of the C corporation structure is that it’s the only entity that supports 401(k) business financing (formally called the Rollovers for Business Start-ups (ROBS) arrangement.) ROBS allows entrepreneurs to use their retirement funds as business financing without incurring tax penalties or early withdrawal fees. This increasingly popular funding arrangement is executed by taking the proper steps to allow for a pre-tax retirement account to ‘invest’ in a business. As a result, the 401(k) plan becomes a shareholder in the corporation and the retirement funds are transferred to a plan hosted by the corporation. Because C corps are the only entity that allows selling stock ownership for cash, they’re the only structure that supports the ROBS arrangement.
Those who are looking to recapitalize an existing business via the ROBS structure can elect to change a pass-through entity, such as an LLC, to a C corp, so they too can benefit from this type of debt-free business financing.
Learn more about Rollovers for Business Start-ups in our Complete Guide to ROBS.
C Corps Are Beneficial for Small Business
Selecting a corporate structure isn’t a decision that entrepreneurs take lightly. As businesses grow and evolve, owners may need to change the structure. The C corp model doesn’t just fit huge multinationals; small companies can benefit greatly from the potential small business tax deductions, and they may completely mitigate the effects of double taxation.
Business owners should always consult with a tax professional and prepare to adjust their organizational strategies constantly, but considering the impact of taxes on a fledgling business enterprise, it can prove well worth the effortto make the C corporation setup work for you.