As of now, the highest marginal tax rate is 37%. Combine this with state income taxes, net investment income tax, and the Medicare surcharge, and you will find that many taxpayers are paying 40%-50% at the highest tax bracket.
Based on these tax rates, it makes sense for self-employed individuals to examine other tax strategies that can lower their overall effective tax rate. One of these tax strategies is utilizing certain advantages afforded to C-Corps that can effectively reduce the overall tax burden.
A C-Corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. But a C-Corporation can also take certain deductions that are not afforded to other tax entities. A corporation can conduct its business, realize any net income (or net loss), pays taxes, and distributes profits to shareholders.
A-C Corp is essentially a self-contained entity. What I mean by this is that it pays its federal tax and state tax (if applicable). If the corporation decides to issue a dividend, this dividend is taxable to the shareholders.
Since C-Corp net profits do not pass through to the shareholders, they are first taxed at the corporate level and then taxed as a dividend distribution to the individuals. Dividend payments are not deductible by the C-Corp.
The corporate profit is taxed when earned and then taxed again to the shareholders when dividends are distributed. This results in double taxation. Unfortunately, the corporation does not receive a tax deduction when distributing dividends to shareholders.
C Corp double taxation is a concern for a lot of clients. But I have found that they are the best tax structure for many clients. This is often the case due to the abundant fringe benefits available to the C Corps. But let’s take a closer look at C Corp double taxation and how it works.
But this may not be as big of a problem as you may think. First, C Corp profits up to $50,000 are taxed at the low rate of 15%. Second, the distributed dividends are taxed at a preferred rate of 15% but can be taxed as high as 20%, depending on your tax situation. When you combine these rates, you have a rate of 30%.
But let’s assume that you are in the 28% tax bracket. This would then be 2% lower than the combined rate on the C Corp (taking under $50,000 of profit) and the dividend distribution. So considering this situation, one would think that the C Corp doesn’t make a lot of sense.
But on closer review, you will find a couple of things:
- The C Corp allows you to time the dividend distribution in a lower tax bracket.
- Having the income taxed in the C Corp may allow you to deduct certain tax credits (child or education credits) that you may have been phased out of.
- The C Corp can have many fringe benefits that are not deductible under an S Corp structure.
Considering that the C Corp can deduct these fringe benefits, this one issue alone can more than offset the 2% increase in the overall tax rate. Now, most people may not need to take advantage of these fringe benefits, but it makes a lot of sense for the right person. A-C Corp may work for you depending on your situation, even considering C Corp double taxation.
With higher personal tax rates in effect, we are seeing a shift by some taxpayers to a C Corporation structure. Although there are many advantages to a C Corp structure, it usually is not the best entity for the small business owner, especially a start-up business. Let me give you an example of how a C Corporation created significant problems for my client.
I had a new client become involved in his C Corporation tax return audit. But the curious part is that he had no idea that he had a C Corp. He had been operating under this structure for eight years but had no idea how C Corps worked, nor did he understand the advantages and disadvantages associated with the structure. His prior accountant offered no support and probably did not know much about C Corps. In fact, who knows why he was even set up as a C Corp in the first place.
He had historically always reported losses on his C Corp return. The problem was that the IRS had disallowed numerous expenses and assessed tax (including, of course, penalties and interest) against the business. In addition, since he was distributing income out of the corporation to pay his personal expenses, the IRS was considering this a dividend distribution along with the related tax. The IRS even assessed employment taxes against him for what they deemed a reasonable wage.
The result was a big tax mess that cost him time and money. This example highlights the significant disadvantages of the C Corp structure.
So you might be asking the question…why would it make sense to be subject to double taxation? The answer is that it doesn’t make sense in most situations. However, it can make a lot of sense for some taxpayers (especially those in higher tax brackets).