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Jacob D. Favaro
Jacob D. Favaro

The reemergence of C corporations

Practitioners should evaluate whether a C corporation might be a better choice of entity than an S corporation now that top individual income tax rates have risen.

December 18, 2014
by Jacob D. Favaro, CPA

Making the leap to start their own business is a huge decision that weighs on many entrepreneurs’ minds. They must consider several factors, including, but not limited to, choice of entity, sources of capital, fringe benefits, ownership structure, liability protection, and income taxes. With the maximum individual income tax rate increased to 39.6% after the passage of the American Taxpayer Relief Act of 2012 (ATRA), P.L. 112-240, many individuals are looking for ways to reduce their overall income tax burden. ATRA has made it even more important to choose the best entity structure for a new business.

Given the right facts and circumstances, C corporations, which are taxed under subchapter C of the Code, can help minimize the overall income tax burden. In addition, C corporations may offer significant advantages over other entities, especially S corporations (which generally are taxed at the shareholder level as passthroughs), including the treatment of fringe benefits, reduced rate of capital gains taxation on the sale of qualified small business stock under Sec. 1202, ease of stock transfers, lower tax rates on the first $100,000 of net income, and flexibility in raising capital.

Fringe benefits

Fringe benefits such as health insurance premiums paid by the corporation can be received tax free by the owners of a C corporation. Additionally, the corporation can fully deduct these premiums. S corporation owners must report these benefits as income and then deduct the premiums from gross income on their individual income tax return, resulting in a “wash” for income tax purposes. While the S corporation will receive a full deduction for these premiums, the net deduction passed through to the shareholders will likely be less than their share of premiums unless there is a single owner or equal owners with the exact same cost of insurance.

Additionally, a C corporation can fully deduct long-term-care and disability insurance premiums without any additional income reported to the owners. S corporation owners would have to pick up these benefits as gross income for the S corporation to fully deduct these premiums. Lastly, where most owners of a C corporation are also employees, a medical reimbursement plan under Sec. 105(b) allows the C corporation to cover all medical expenses not paid for by the insurance plan. As long as the plan is nondiscriminatory, the reimbursements are not taxable to the employees. However, to avoid penalties under the Patient Protection and Affordable Care Act, P.L. 111-148, beginning in 2014, a medical reimbursement plan generally must be integrated with a group health plan (see Notice 2013-54).

Deduction allowed

Cost

C corp.

S corp.

 

Cost of health insurance

$15,000

$15,000

$15,000

 

 

Cost of long-term-care insurance*

$10,000

$10,000

 

 

Cost of disability insurance

$5,000

$5,000

 

 

Total deduction

$30,000

$15,000

 

 

* The cost of long-term-care insurance can possibly be allowed as an individual deduction.

 

Qualified small business stock

C corporations also offer a reduced rate of capital gains tax on the sale of qualified small business stock (QSBS), as defined in Sec. 1202. In addition to some others, the main requirements needed to qualify as Sec. 1202 stock are that the shares must be held at least five years and at least 80% of the assets must be used in a qualified trade or business that is not a business in certain personal services (e.g., accounting, law, architecture, or actuarial services).

Currently, owners of QSBS can exclude 50% of the gain on the sale if the shares were acquired after Dec. 31, 2013. The maximum gain that can be excluded is limited to the greater of $10 million or 10 times the taxpayer’s basis in the stock. The tax rate on the reported gain is subject to a 28% tax rate, or an effective rate of 14% on the entire realized gain. If a taxpayer happens to be subject to the alternative minimum tax (AMT), the AMT adjustment for this gain will bump up the effective rate to 15%. The highest current rate on other long-term capital gains is 20%. Taxpayers fortunate enough to have obtained QSBS between Sept. 28, 2010, and Dec. 31, 2013, can exclude 100% of the gain on that stock. Additionally, the AMT adjustment does not apply to stock obtained during that period.

The following is an example of potential tax savings for an individual who sells qualifying Sec. 1202 stock:

Stock acquired

Stock acquired from

after 12/31/13

9/28/10–12/31/13

Basis of QSBS

$10,000

$10,000

Sales proceeds received

$50,000

$50,000

Realized gain

$40,000

$40,000

Exclusion

$20,000

$40,000

Taxable gain

$20,000

$0

Tax

$5,600

$0

Effective rate

14%
0%

Stock transfers

An additional advantage of C corporations is the ease of stock ownership and transfers of stock. C corporations can have more than one class of stock, but S corporations may not. Companies may want to distinguish certain owners from others, giving them a stronger voice in business operations. This can be achieved by giving those owners a class of stock that contains all the voting rights, and creating an additional class of stock for owners that are merely investing in the company. C corporations can have an unlimited number of shareholders, but an S corporation is limited to 100 shareholders.

Few restrictions apply to transfers of C corporation stock. Business owners that have a growing business and want to offer the company stock publicly will find that a C corporation structure is usually required. S corporations and limited liability companies (LLCs) typically have buy-sell agreements that restrict the transfer of the business to others, unless the transfer is approved by the other shareholders or members.

Raising capital

Another advantage of a C corporation is the ease of raising equity capital from multiple sources. The Jumpstart Our Business Startups (JOBS) Act of 2012, P.L. 112-106, allows the SEC to revise its rules to enable businesses to raise capital through crowdfunding. Crowdfunding involves funding a project by raising money in small amounts from a large number of people. It allows companies to sell stakes to small investors without registering with the SEC.

This makes it cheaper and less cumbersome for startups to raise capital when they are trying to get a business up and running. The companies are required to raise money through regulated broker-dealers or crowdfunding portals such as Kickstarter. Crowdfunding is growing in popularity, especially among the younger generation. Many young entrepreneurs are turning to this as an option for raising capital. Since S corporations have the 100-shareholder limit, crowdfunding is generally not a viable option for them. Additionally, some investors do not want the burden of flowthrough taxation, i.e., Schedule K-1s.

Liability protection

Another benefit of a C corporation is that shareholders are protected from personal liability, meaning shareholders are not liable for any of the corporation’s debts. S corporations, because they are state law corporations for nontax purposes, also provide this protection. LLCs and limited partnerships (for limited partners) can achieve the same protection if they are properly structured and operated, but the liability protection is less certain than that for C and S corporations. Liability protection is a major benefit if an entity fails.

In addition, if a corporation that fails is structured properly from the beginning, it can give rise to Sec. 1244 losses on small business stock for its shareholders. Sec. 1244 permits an ordinary loss deduction of up to $100,000 for joint taxpayers, not the capital loss that for individual taxpayers is limited to $3,000 per year. S corporation shareholders, on the other hand, may not be able to use the losses the corporation incurred if they have no basis in their stock.

Lower taxes

Small businesses taxed as C corporations can achieve favorable treatment if taxable income is reduced to $75,000 or less. This first $50,000 is taxed at 15%, and the next $25,000 is taxed at 25%. An individual with flowthrough income from an S corporation or partnership who is in the highest income tax bracket pays a rate of 39.6%. Individuals who have other investments or income that push them into higher tax brackets can shelter some of their income if their operating business is a C corporation and the profits are retained in the business for working capital.

Many advisers warn of “double taxation” within a C corporation. While this is definitely a consideration for businesses that will be looking to make distributions of earnings to the owners or that plan to ultimately sell the company via an asset sale, the impact of double taxation can be mitigated through a sale of stock, as opposed to a sale of the company’s assets.

Additionally, if it appears that double taxation will be a problem in future years, the corporation can subsequently elect to become an S corporation. After 10 years as an S corporation, the corporation can sell the assets and not worry about double taxation. Hopefully, the years as a C corporation benefit the shareholders in some of the ways mentioned above.

The following chart shows an example of an individual taxpayer in the highest tax bracket with additional business income of $75,000:

C corp.

S corp.

Partnership

Business income

$75,000

$75,000

$75,000

Income tax

$13,750

$29,700

$29,700

Cash retained as working capital

$61,250
$45,300
$45,300

Now assume the same facts as above, but instead of being retained as working capital, the leftover cash is paid out as a dividend.

C corp.

S corp.

Partnership

Business income

$75,000

$75,000

$75,000

Tax on business income

$13,750

$29,700*

$29,700*

Cash paid as dividend/distribution

$61,250

$45,300

$45,300

Owner’s income tax on dividend

$14,578**

Net cash to owner

$46,672
$45,300
$45,300

*Paid at the owner level on the income passed through from the entity.
**In this example, the taxpayer is subject to the 3.8% net investment income tax on this income in addition to the 20% tax rate on qualified dividends.

As the examples demonstrate, an individual can save on his or her overall income tax burden by structuring the company as a C corporation if he or she is already in the highest tax bracket and can manage to lower the C corporation’s income. Being taxed as a C corporation for several years, as in the above example, combined with a switch to an S corporation at least 10 years before a sale, may end up saving a great deal of income taxes.

Taxpayers should choose the type of entity they want while keeping the endgame in mind. Factors such as that the top individual rate is greater than the top corporate rate, combined with the growing popularity of obtaining capital from outside sources such as crowdfunding, have helped C corporations gain popularity over the last couple of years. C corporations can work well under the appropriate circumstances and should no longer be treated like the unwanted stepchild of entity structure. As long as the maximum tax bracket of C corporations is lower than the maximum tax bracket for individuals, they will remain an attractive entity choice.

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Jacob D. Favaro, CPA, CFP, is a senior manager in tax with Keiter CPAs in Glen Allen, Va.