The classification of a business relationship may have profound tax consequences. Opting to have your business operating as a C corporation can offer important advantages that a pass-through entity, such as an S corporation, partnership, or LLC cannot.
What Is a C-Corporation?
A C corporation (‘C-Corp’) is a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. This means that as a corporation, C-Corps can sue (or be sued) in its own name; it can buy, own, and use its own real or personal property; make its own contracts and guarantees; lend money and invest funds.
What Are Some of the Advantages of C-Corps?
C-Corps limit the personal liability of the directors, shareholders, employees, and officers, meaning that C-Corp is a separate legal entity that protects the owners’ personal assets from creditors. Once formed, a C-Corp has a life of its own, with its own rights, capabilities, responsibilities, and liabilities. In this way, the business’s legal obligations cannot become a personal debt obligation of any individual associated with the corporation.
A shareholder can freely sell his corporate shares, and the buyer will acquire the former shareholder’s economic and management rights. Unless the corporation’s governing documents provide otherwise, there are no restrictions on owning stock in a C-Corp.
Unlike S corporations, C-Corps are permitted to have different ownership interests (i.e. common stock and convertible preferred stock or debt) and can have an unlimited number of owners. C-corps may be able to issue qualified small business stock, enabling individual shareholders to exclude some or all of the capital gain on the sale of their stock under Internal Revenue Code Section 1202. C-Corps can also be acquired in a tax-free reorganization or more easily sell equity in an initial public offering.
Because a C-Corp exists separately from its shareholders, it has a perpetual existence; the C-Corp continues to exist even if the owners change and members of the board of directors are replaced.
Another benefit of a C-Corp over an S corp or LLC is that it is easier to attract investors, including obtaining capital through equity financing. Start-up ventures seeking venture capital financing often are formed as C-Corp because many institutional investors are more comfortable with the corporate form.
How Are C-Corps Taxed?
The principal disadvantage of a C-Corp is the double tax on earnings distributed to shareholders as dividends and, if the corporation holds highly appreciated assets (i.e. real estate), the additional tax cost when the business is sold and liquidated.
Since a corporation is a distinct tax-paying entity unless it makes an election to be taxed as an S corporation, C-Corp will pay corporate income tax on its income after offsetting income with losses, deductions, and credits. It can select its own taxable year and accounting methods, computes its taxable income under general tax principles, file a corporate income tax return (Form 1120).
The C-Corp will pay the shareholder through dividends from its after-tax income, and subsequent, the shareholders will have to pay personal income taxes on the dividends received. Any portion of the profits paid to owners as salaries or dividends becomes reportable income on the owners’ personal income tax returns. Although double taxation is an unfavorable outcome, the ability to reinvest profits in the company at a lower corporate tax rate is an advantage.
Tax Benefits of a C-Corp
Since the beginning in 2018, with the reduction of the corporate income tax rate to 21% (with the new proposed increase of the flat tax from 21% to 28%), some closely held businesses may find it more advantageous to operate as C-Corp notwithstanding the double taxation, especially if there is no immediate need to withdraw earnings or dividends.
Virtually all a C-Corp’s routine expenses are deductible either as business expenses under, losses under, or depreciation. So, C-Corps can deduct business losses, including casualty losses without limitation, and all bad debts are fully deductible as a business bad debts.
Shareholders of C-Corps can work for the corporation as salaried employees. Although these salaries and bonuses are subject to payroll taxes and Social Security and Medicare contributions, the C-Corp can, then, deduct its full share of payroll taxes. In addition, the company can pay employees enough so that no taxable income remains at the end of the fiscal year.
One more advantage of C-Corps entities is that they can deduct contributions to eligible charities as a business expense up to 10 percent of taxable income within the taxable year. The C-Corp can also carry over charitable donations above the limit to the next five tax years too.
How the Business Entity Formation Lawyers at Evolution Tax and Legal Can Help
Choice of entity decisions also are heavily influenced by the type of business, the owners’ desire either to withdraw earnings or reinvest them in the business, the composition of and relationships among the investors, and the exit strategy, compensation and fringe benefit considerations, compliance costs, and state and local taxes.
Operating as a C-Corp may involve additional complexity. Still, it also provides a wide array of tax planning opportunities across the business life cycle. There are many ways to reduce or eliminate double taxation and still enjoy C-Corp benefits for your business. So, the tax implications of being a C-Corp versus an S corporation or LLC should be discussed with a trusted tax adviser.
The business formation attorneys at Evolution Tax and Legal have worked with countless business owners to register as a business entity and ensure they receive the benefits that will work for their business. To start your journey to becoming a business entity today, contact Evolution Tax and Legal.