Tax Advantages of a C Corporation
Using Your Personal Business Model in Entity Selection
Many who complete the work in Business Model YOU are attracted to buying or starting their own business. There are many confusing choices (and lots of confusing advise) to be considered. In working with people interested in getting funded by using their own retirement plans, ERPA, I have run across those who feel that because a C Corporation is used, it's a poor choice. Most are very aware that a C Corporation is a very independent entity and therefore pays its own taxes. Then the owners also pay taxes on any profits (through dividends) they receive from the business as well. This is often called "double taxation." Alternatives, such as disregarded and Pass-thru entities, do not pay tax at the corporate level, often making them seem to be a superior choice. However, these entities come with other attributes that sometimes make the C Corporation a better choice. What is fascinating about this tax issue is that a very simple Business Model contributes to helping the entrepreneur make a wise technical financial decision. To understand how this works, we need to leave taxes and quickly discuss an important aspect of business models.
In the Business Model YOU page introducing the COSTS segment, you would have expected a discussion of hard vs soft costs, or profitability. In fact, almost 80% of the page is devoted to the critical ideal of "Scalability". When creating or reinventing a business model, seeking scalability is almost always a fundamental step. The following business model illustrates scalability.
In the Business Model YOU page introducing the COSTS segment, you would have expected a discussion of hard vs soft costs, or profitability. In fact, almost 80% of the page is devoted to the critical ideal of "Scalability". When creating or reinventing a business model, seeking scalability is almost always a fundamental step. The following business model illustrates scalability.
The right-hand side of the business model shows how we expect to make money, by providing value to customers who will pay for it. This is illustrated with yellow notes. The left side shows how that value is created, illustrated with both green and red notes. The change in color is very important. Red items, such as your own personal resources, are limited. If you hire another "you" it may cost as much (or more) than you to do the work yourself. This is a non-scalable business model. However, if we can use other resources, such as technology or cost effective labor and assets, where creating more value can be done at ever decreasing marginal costs, the business is scalable. These are the ones that many, including investors and your government, want to flourish. The tax mechanisms associated with C Corporations were created to help this kind of cost effective organization to get started and grow. The disregarded and pass-thru mechanisms are more appropriate for the personal and non-scalable business models. We will now look at specific technical issues to illustrate cases where a C Corporation is advantageous; however, the reader should also be able to see the scalability pattern emerge.
Corporate Formation
A non-scalable business model is useful where growth is not an objective. The model produces enough profits to justify the expenditure of Key Resources, often YOU, and there is no need for more. The simplicity of disregarded and Pass-thru entities are a nice fit. Entrepreneurs are more often driven by a growth objective. Growth generally requires other people's time and money. Here is where making the organization a completely separate entity, as in a C Corporation, begins to shines.
To better illustrate this idea of separateness as a tax advantage, let's compare a C and an S Corporation. To be eligible for S status, S Corporations shareholders must:
The C Corporation, which pays it own taxes directly, does not need to concern itself with these limitations. So what are the additional opportunities for a C Corporation to get other people's money and time?
Investors: A large group of those interested in a scalable opportunity are excluded unless a C Corporation is used. For example:
Sweat Equity Employees: It's frequently possible to get top notch talent you cannot afford early on if there is a good possibility there is a large sum of money to be made once the model is successful. Perhaps the easiest vehicle is stock options. There are countless stock option millionaires (or at least stories about them) that attract talent. Beware, these hinge on going public and that requires a C Corporation. While on the subject of benefits, the C Corporation owner is not taxed for company medical benefits where the S Corporation owner must declare them as a part of their taxable income.
Mergers: Often valuable business assets are already in place in someone else's company. A fast track to success is to merge or acquire their assets with your model, money, and talent. Your government encourages this method of capital formation by allowing these assets to be placed into the new business without taxing the original owner, provided the result is a C Corporation (for some examples, research a Section 351 tax transaction or Section 338 (h)(10) election).
This last situation deserves some additional attention to the very sketchy business model we have used so far. Let's give this model some additional history. It is commonly seen in those who have developed significant business skills in a corporate environment and now either desire or are being forced to use those skills in their own venture. The perfect partner for this individual is an existing business owner who has been successful in their trade but is now burning out with all the additional administrative work a growing business requires. This is the partner who can take advantage of Section 351 to form a new C Corporation with the exiting corporate executive.
ERPA Investment: Retirement funds are available for investment, if it is sound and only with a C Corporation. There is just some down to earth wisdom here. Your retirement funds should be invested as well as possible. If you have worked, tested, pivoted, and proven your business model, this may indeed be the best place for your retirement funds. If you are considering a completely non-scalable business model, you should think twice about this finding source with retirement monies. The problem is not that a C Corporation is required; it's that you are putting your retirement money into what may be a marginal investment and you should be doing better for your future than that.
There is another warning here about the use of retirement funds in your own business. There is a popular concept floating around called the "checkbook LLC" where an IRA funds an LLC which then gives the owner authority to use its checkbook and buy a business. First of all, that income will be subject to UBIT, the Unrelated Business Income Tax. Don't be surprised if that doesn't get quickly over 35%. Secondly, it's almost impossible not to get into a prohibited transaction. Two partners recently found they unknowingly did this when they personally guaranteed a loan for their business which was purchased with IRA funds. That cost each one of them $225,000 in taxes plus more than $45,000 in penalties. Had they used an ERPA plan with a 401(k) in a C Corporation, this transaction would have been allowed.
To better illustrate this idea of separateness as a tax advantage, let's compare a C and an S Corporation. To be eligible for S status, S Corporations shareholders must:
- Not be a partnership, corporation, or non-resident alien
- All hold the same class of stock
- Be 100 or less in number
The C Corporation, which pays it own taxes directly, does not need to concern itself with these limitations. So what are the additional opportunities for a C Corporation to get other people's money and time?
Investors: A large group of those interested in a scalable opportunity are excluded unless a C Corporation is used. For example:
- Vendors and Customers - Often not "individuals" and therefore unable to hold S Corp stock, these organizations often invest in opportunities that not only have great return possibilities, they have immediate benefits to their own operations
- Private Equity and Angels - These groups will see the potential in your scalability and want to be a part of growing it and then going public; but wait, that can't happen with fewer than 100 shareholders
- Foreign investors: These are not only those you may know. There are many seeking opportunities to enter the US with E2 or EB5 visas. These allow a foreign national to enter or even immigrate to the US if they make a substantial investment here.
- Cautious investors: As a C Corporation you can bring in preferred shareholders who hold higher security and may get better returns but will not dilute your ownership. A new enterprise is also sometimes considered "thinly capitalized" by the IRS. This happens where someone does something like invests $100,000 in the venture but wants $1,000 to be stock and $99,000 to be a loan. The IRS can re-characterize that loan as preferred stock and if you were an S Corp before, you aren't one now.
- Crowdfunding - The Jumpstart Our Business Startups (JOBS) Act of 2012 has open the door for finding many small investors for your company over an internet Crowdfunding portal. The advantage to an entrepreneur is that these are small investors and not likely to want to take control of the business from you. While it may take the SEC many years to regulate crowdfunding to prevent scams, several things seem apparent. First, to sell stock in your company you need to have stock, so the entity needs to be a Corporation. An S Corporation is a poor choice because it prohibits both foreign shareholders and more than 100 shareholders. To be successful here, you don't want either limitation even is the SEC eventually allows it.
Sweat Equity Employees: It's frequently possible to get top notch talent you cannot afford early on if there is a good possibility there is a large sum of money to be made once the model is successful. Perhaps the easiest vehicle is stock options. There are countless stock option millionaires (or at least stories about them) that attract talent. Beware, these hinge on going public and that requires a C Corporation. While on the subject of benefits, the C Corporation owner is not taxed for company medical benefits where the S Corporation owner must declare them as a part of their taxable income.
Mergers: Often valuable business assets are already in place in someone else's company. A fast track to success is to merge or acquire their assets with your model, money, and talent. Your government encourages this method of capital formation by allowing these assets to be placed into the new business without taxing the original owner, provided the result is a C Corporation (for some examples, research a Section 351 tax transaction or Section 338 (h)(10) election).
This last situation deserves some additional attention to the very sketchy business model we have used so far. Let's give this model some additional history. It is commonly seen in those who have developed significant business skills in a corporate environment and now either desire or are being forced to use those skills in their own venture. The perfect partner for this individual is an existing business owner who has been successful in their trade but is now burning out with all the additional administrative work a growing business requires. This is the partner who can take advantage of Section 351 to form a new C Corporation with the exiting corporate executive.
ERPA Investment: Retirement funds are available for investment, if it is sound and only with a C Corporation. There is just some down to earth wisdom here. Your retirement funds should be invested as well as possible. If you have worked, tested, pivoted, and proven your business model, this may indeed be the best place for your retirement funds. If you are considering a completely non-scalable business model, you should think twice about this finding source with retirement monies. The problem is not that a C Corporation is required; it's that you are putting your retirement money into what may be a marginal investment and you should be doing better for your future than that.
There is another warning here about the use of retirement funds in your own business. There is a popular concept floating around called the "checkbook LLC" where an IRA funds an LLC which then gives the owner authority to use its checkbook and buy a business. First of all, that income will be subject to UBIT, the Unrelated Business Income Tax. Don't be surprised if that doesn't get quickly over 35%. Secondly, it's almost impossible not to get into a prohibited transaction. Two partners recently found they unknowingly did this when they personally guaranteed a loan for their business which was purchased with IRA funds. That cost each one of them $225,000 in taxes plus more than $45,000 in penalties. Had they used an ERPA plan with a 401(k) in a C Corporation, this transaction would have been allowed.
Corporate Operations
C Corporations have a small build-in tax shelter. Currently, the first $50,000 of earnings are generally taxed at only 15%. Generally because the IRS has exceptions to this. For example, if all the corporation does is personal service work (generally non-scalable), it is a Personal Service Corporation and pays a higher flat tax on all income. Allowing a new enterprise to keep the first $50,000 of earnings at this low tax rate encourages the growth of new C Corporations. The income of a disregarded or Pass-thru entity is the marginal tax rate of the shareholders, often 28% or more.
One of the "Bush-era tax cuts" allows owners of small C Corporations to survive double taxation with little consequence. This is known as Qualified Dividends. The current tax law allows the owners of a qualified C Corporation to pay reduced taxes on their dividends according to their ordinary income tax rate. Here is how that breaks down for some common tax brackets in 2012:
Ordinary tax rate 15% - Tax on Qualified Dividends 0% - Savings to offset Corporate level tax 15%
Ordinary tax rate 28% - Tax on Qualified Dividends 15% - Savings to offset Corporate level tax 13%
Ordinary tax rate 33% - Tax on Qualified Dividends 15% - Savings to offset Corporate level tax 18%
The idea is that while the business is small and only subject to that 15% corporate level tax, there is little difference between paying corporate + qualified dividend tax as opposed to passing through income at ordinary rates. Of course this diminishes as increasing corporate profits get taxed at higher rates; but the issues of increasing success are the kinds of problems we all would rather be solving. One point to always keep in mind is that in general corporate tax rate and lower than individual tax rates; however, distributing profits creates a high double tax effect. If a C Corporation is managed so that the owners take compensation in wages and benefits rather than through distribution, they avoid the ongoing double tax.
Another cautionary point here, Qualified dividends currently only exist to the end of 2012. We may not know what Congress will do about them until very late in the year.
Be aware that Pass-thru entities are frequently abused by their owners seeking to minimize their payroll taxes by taking their earnings as profits where they are not subject to self employment taxes. The IRS is well aware of these techniques and has audit programs specifically targeting them. These possibilities are not open to C Corporation shareholders so they are not exposed to these audit traps.
Now renting or leasing property to your C Corporation can be a way to extract those profits without paying Social Security taxes. There are regulations (Sec 1.469-2(f)(6)) that clarify whether it is passive or non-passive; however, either way it is not subject to self-employment tax.
One reason ERPA requires a C Corporation is that they have the broadest spectrum of tax free benefits of any taxable entity type and ERPA requires one of those benefits. This includes tax-free Section 105 (Health Reimbursement) plans for employee-owners without having to use a tax gimmick such as hiring your wife and being her dependent. Until they grow large enough for their own tax staff, owners of C Corporations are often able to control the taxable earnings of a C Corporation by offering additional benefits as they can afford them.
Disregarded and Pass-thru entities have their taxes paid directly by their owners. Because of this, the IRS requires that the entity have a fiscal year that matches the owner's as closely as possible. With all "individual" owner's, that will mean a calendar year. The C Corporation has no tax relationship with its owners and is free to choose any appropriate fiscal year. The C Corporation can close their tax year at the end of a calendar quarter other than the 4th (Dec 31), allowing it to span two calendar years. There is now some degree of freedom in choosing which calendar year to recognize salary or corporate deductions.
The C Corporation also requires a degree of formality not necessary with other entities, especially the popular LLC. If the business model anticipates growth through the use of other people's money, the importance of maintaining this formality cannot be stressed enough. There is a fiduciary responsibility to using those funds and having as complete a set of records as possible goes a long way to fulfilling that responsibility. This is a legal rather than a tax issue and an area where your attorney can best assist you.
One of the "Bush-era tax cuts" allows owners of small C Corporations to survive double taxation with little consequence. This is known as Qualified Dividends. The current tax law allows the owners of a qualified C Corporation to pay reduced taxes on their dividends according to their ordinary income tax rate. Here is how that breaks down for some common tax brackets in 2012:
Ordinary tax rate 15% - Tax on Qualified Dividends 0% - Savings to offset Corporate level tax 15%
Ordinary tax rate 28% - Tax on Qualified Dividends 15% - Savings to offset Corporate level tax 13%
Ordinary tax rate 33% - Tax on Qualified Dividends 15% - Savings to offset Corporate level tax 18%
The idea is that while the business is small and only subject to that 15% corporate level tax, there is little difference between paying corporate + qualified dividend tax as opposed to passing through income at ordinary rates. Of course this diminishes as increasing corporate profits get taxed at higher rates; but the issues of increasing success are the kinds of problems we all would rather be solving. One point to always keep in mind is that in general corporate tax rate and lower than individual tax rates; however, distributing profits creates a high double tax effect. If a C Corporation is managed so that the owners take compensation in wages and benefits rather than through distribution, they avoid the ongoing double tax.
Another cautionary point here, Qualified dividends currently only exist to the end of 2012. We may not know what Congress will do about them until very late in the year.
Be aware that Pass-thru entities are frequently abused by their owners seeking to minimize their payroll taxes by taking their earnings as profits where they are not subject to self employment taxes. The IRS is well aware of these techniques and has audit programs specifically targeting them. These possibilities are not open to C Corporation shareholders so they are not exposed to these audit traps.
Now renting or leasing property to your C Corporation can be a way to extract those profits without paying Social Security taxes. There are regulations (Sec 1.469-2(f)(6)) that clarify whether it is passive or non-passive; however, either way it is not subject to self-employment tax.
One reason ERPA requires a C Corporation is that they have the broadest spectrum of tax free benefits of any taxable entity type and ERPA requires one of those benefits. This includes tax-free Section 105 (Health Reimbursement) plans for employee-owners without having to use a tax gimmick such as hiring your wife and being her dependent. Until they grow large enough for their own tax staff, owners of C Corporations are often able to control the taxable earnings of a C Corporation by offering additional benefits as they can afford them.
Disregarded and Pass-thru entities have their taxes paid directly by their owners. Because of this, the IRS requires that the entity have a fiscal year that matches the owner's as closely as possible. With all "individual" owner's, that will mean a calendar year. The C Corporation has no tax relationship with its owners and is free to choose any appropriate fiscal year. The C Corporation can close their tax year at the end of a calendar quarter other than the 4th (Dec 31), allowing it to span two calendar years. There is now some degree of freedom in choosing which calendar year to recognize salary or corporate deductions.
The C Corporation also requires a degree of formality not necessary with other entities, especially the popular LLC. If the business model anticipates growth through the use of other people's money, the importance of maintaining this formality cannot be stressed enough. There is a fiduciary responsibility to using those funds and having as complete a set of records as possible goes a long way to fulfilling that responsibility. This is a legal rather than a tax issue and an area where your attorney can best assist you.
Corporate Liquidation
All good things must come to an end and that includes an ownership in a C Corporation (the Corporation itself can easily out live any of its owners). Selling the assets of a C Corporation to liquidate it is a double-taxation event that needs to be carefully planned for as the Corporation will pay capital and ordinary tax (which are both at the same rate) on the sale of the assets and then the owners get to pay similar personal taxes on the final distributions of the liquidation. There are Exit Planning strategies beyond the scope of this article that can make a huge after-tax difference here. The overall objective is to move what assets you can out of the C Corporation. This can include things like the creation of self-rentals (as mentioned earlier), unfunded retirement programs, allocation of personal goodwill, and many other possibilities. They all take time to execute. You can Contact Us for information about these.
An interesting aspect of double taxation is that it is generally seen as a problem during operations when there are many mitigating opportunities to minimize its effect. It's monstrous effect at liquidation, where a seller is often thrown into the highest possible tax brackets, is not as well understood and Exit Planning strategies are not nearly as prevalent as one would think.
Selling the stock is a different story. For an individual, the sale of stock is a capital gain or loss with preferential tax rates. Corporate stocks in small businesses also have some special aspects
If the model fails: The bad thing about an individual with a capital loss is that they can generally only be applied to offset capital gains. If the rest of your income is all ordinary, you can only apply a few thousand dollars each year of the loss and the rest carries forward. An exception to this is if the business qualifies, Section 1244 allows that loss to also offset ordinary income. Smallness counts here, so this is a consideration for the corporate model that just never gets off the ground.
If the model is moderately successful: Section 1202 was enacted to encourage people to invest in small businesses. For a Qualifying Small Business where stock has been held for more than 5 years, non-corporate investors can exclude much of their profit from the sale of their stock. That can mean anywhere from a 50% to 100% exclusion from income. Congress seems to play with the exact amount depending on how guilty they feel about the current economy. 1202(c)(2)(A) reserves this exclusion for C Corporation stock.
If the model is hugely successful: Your Key Resources have vastly changed and most likely your perception of your life's purpose. It's now time for an Exit Plan or Private Capital Restructuring strategy. Private Capital Restructuring is our process of moving value out of a business and into the owner's personal estate without removing the owner's control of the business. A good metaphor for this would be "taking chips off the gambling table.' For more information Contact Us.
An interesting aspect of double taxation is that it is generally seen as a problem during operations when there are many mitigating opportunities to minimize its effect. It's monstrous effect at liquidation, where a seller is often thrown into the highest possible tax brackets, is not as well understood and Exit Planning strategies are not nearly as prevalent as one would think.
Selling the stock is a different story. For an individual, the sale of stock is a capital gain or loss with preferential tax rates. Corporate stocks in small businesses also have some special aspects
If the model fails: The bad thing about an individual with a capital loss is that they can generally only be applied to offset capital gains. If the rest of your income is all ordinary, you can only apply a few thousand dollars each year of the loss and the rest carries forward. An exception to this is if the business qualifies, Section 1244 allows that loss to also offset ordinary income. Smallness counts here, so this is a consideration for the corporate model that just never gets off the ground.
If the model is moderately successful: Section 1202 was enacted to encourage people to invest in small businesses. For a Qualifying Small Business where stock has been held for more than 5 years, non-corporate investors can exclude much of their profit from the sale of their stock. That can mean anywhere from a 50% to 100% exclusion from income. Congress seems to play with the exact amount depending on how guilty they feel about the current economy. 1202(c)(2)(A) reserves this exclusion for C Corporation stock.
If the model is hugely successful: Your Key Resources have vastly changed and most likely your perception of your life's purpose. It's now time for an Exit Plan or Private Capital Restructuring strategy. Private Capital Restructuring is our process of moving value out of a business and into the owner's personal estate without removing the owner's control of the business. A good metaphor for this would be "taking chips off the gambling table.' For more information Contact Us.
