Picking the right business structure is one of the biggest decisions that entrepreneurs make when starting a new small business. To protect personal assets from company liabilities such as lawsuits and debts, business owners usually choose to incorporate. 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?
The biggest differences between business structures emerge clearly around tax time. Limited liability companies (LLCs) and S corps (small business corporations governed by Subchapter S of the Internal Revenue Code) are “pass-through” entities whose profits are reported on the shareholders’ personal tax returns. On the other hand, C corps (governed by — you guessed it! — Subchapter C of the tax code) are not pass-through entities, meaning earnings are taxed at the corporate level and any dividends distributed are taxed at the shareholder’s personal level. Despite many potential small business tax deductions with C corps, many for-profit businesses (which are C corps by default when they incorporate) convert to S corps to avoid the double taxation issue.
Why a C corporation?
Why would small business owners ever opt for the C corp route? Well, despite the potential double tax hit, 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 picking “Option C”:
1. Minimizing your overall tax burden.
Depending on the amount of profit your company makes and your individual tax bracket, a C corporation could help you minimize taxes. As shown in the corporate rate schedule on page 17 of Form 1120, the IRS taxes different levels of profit at different rates, sometimes much lower than individual rates. For example, the first $50,000 in profit is taxed at a rate of 15 percent, as opposed to 28 percent for an individual with that same amount of income.
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% 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 Rollovers for Business Start-Ups (ROBS). 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 Corps Are Good 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; tiny companies can benefit greatly from the potential small business tax deductions, and they may completely mitigate the effects of double taxation. Potential business owners should 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 effort (and the paperwork) to make the C corporation setup work for you.