C-Corporations: Tax Implications
When it comes to federal income taxes, there are usually two tax options for any closely held corporation. It can be what is called a regular “C Corporation” or can elect to be taxed at what is called an “S Corporation”. Any corporation can be a C Corporation but certain eligibility requirements must be satisfied for S status and an S selection must be made.
We start with a regular C Corporation. A C Corporation for income tax purposes truly is separate from its owners. The corporation files its own return and pays its own taxes. Absent the payment of a dividend to a shareholder or the sale of stock by a shareholder, nothing the corporation does will impact the personal income tax returns of its shareholders. As we will see, that’s not the case with S Corporations or its sister entity, the limited liability company.
The tax rate structure for C Corporations provides a benefit to corporations at the lower end of the income scale. The first $50,000 of a C Corporation’s taxable income each year is subject to a favorable 15% tax rate. The rate jumps to 25% on the next $25,000 of taxable income. Thus, the overall rate on the first $75,000 of taxable income is an attractive 18.33%, far less than the personal marginal rate applicable to most successful business owners.
Beyond $75,000, the rate advantage disappears as the marginal rate jumps to 34%. Plus if the corporation’s income exceeds $100,000, the rate bubbles up an additional 5% until any tax savings on the first $75,000 is lost, that is, it’s recaptured by the government.
So many successful C Corporations, those earning over $335,000, end up paying a flat rate of 34% from dollar one. And for those C Corporations that earn more than $10,000,000, the rate jumps to 35% and there is absolutely no tax break for a professional service organization that is taxed as a C Corporation — a law or an accounting firm, an engineering firm, a physician group and any other professional service group. That type of corporation pays a flat 35% from dollar one, so the rate structure benefits companies at the lower end of the earning scale that are not professional service groups.
The biggest negative of a C Corporation is the double tax structure — a corporate level tax and a shareholder level tax. It surfaces whenever the corporation distributes cash or property to its shareholders as a dividend.
The Bush tax cuts reduce the maximum tax on qualifying corporate dividends paid to individuals to 15% and it was reduced to 5% for low income shareholders. These reduced dividend rates have significantly lessened the tax pain of dividends from a C Corporation.
These favorable rates expired at the end of 2012. At this point, it’s anyone’s guess what Congress will do heading into the future. If nothing is done, C Corporation dividends will be taxed like all other income subject to the highest rates applicable to individuals.
It could nearly triple the tax cost of C Corporation dividends for high-end players. The Bush tax cut benefit would then be history. Still, even with the favorable 15% dividend rate, 43.9% of every dollar earned and distributed by a C Corporation which is subject to the marginal 34% rate will be consumed in corporate and shareholder federal income taxes.
And if one assumes that the 15% dividend rate will expire at the end of 2010, and that dividends once again are taxed the same as all other ordinary income, the percentage consumed in corporate and personal federal income taxes could jump to as high as 55.78% for a shareholder subject to a marginal rate of 33%.
Added to these tax numbers are state income tax hits which also are pumped up by the double tax structure. But the grief of the double tax structure is not limited to dividends. It kicks in whenever the assets of the business are sold and the proceeds of the sale are distributed to the shareholders.
Assume for example that a C Corporation sells all of its assets and operations to a strategic buyer for $5,000,000 and that its tax bases in the assets sold is $2,000,000. The corporation would pay a federal income tax of 34% on the $3,000,000 gain, or a total tax of $1,020,000.
If the corporation then distributed the remaining $3,980,000 to its shareholders, that is what’s left over out of the $5,000,000. After the corporation pays its income tax hit, each shareholder would then pay a capital gains tax on the excess of what he or she receives on the distribution over what that specific shareholder paid for his or her stock.
The result is a double tax bite. Because of this double tax rate structure and the government revenues that it generates, any payment from a C Corporation to a shareholder may be scrutinized by the internal revenue service to see if that payment constitutes a disguised dividend that triggers the double tax.
Common examples of disguised dividend include excessive compensation payments to shareholders or the family members, personal shareholder expenses that are paid and deducted as business expenses of the corporation, interest payments on excessive shareholder debt that is reclassified as equity, excess rental payments on shareholder property rented or leased to a corporation, personal use of corporate assets and bargain sales of corporate property to a shareholder, plus payments to purchase or redeem the stock of a shareholder that don’t satisfy complicated attribution in percentage change requirements may trigger taxable dividends. And payments between commonly controlled C Corporations that do not reflect arms-length prices may also result in taxable dividends to the shareholders. The risk of costly double tax disguised dividends is a fact of life with every closely held C Corporation. It’s a risk that S Corporation shareholders do not have to worry about.
Losses sustained by a C Corporation are trapped inside the corporation.
They may be carried back or carried forward by the corporation but they will never be passed through to produce a tax benefit for the shareholders. Any C Corporation, a shareholder’s tax basis in his or her stock is determined only by what was paid for the stock. The stock basis is not increased if the company is profitable, and reinvests its earnings to finance growth.
Assume for example that a corporation has a single shareholder, Jane, who purchased her stock for $100,000, and that the company has accumulated and invested $2,000,000 of earnings over the last 10 years. Jane’s stock basis at the end of year 10 would still be $100,000.
As we will see, if the company had been taxed as an S Corporation from day one, Jane’s basis in her stock at the end of year 10 would have grown to $2.1 million. So on a sale of the stock, Jane will end up paying a capital gains tax on an extra $2,000,000 if the corporation operated as a C Corporation.
Every property transfer between a C Corporation and its shareholders needs to be carefully scrutinized to make certain that inadvertent tax liabilities are not being created. For example, if a person transfers property that is appreciated in value to acquire the stock of a C Corporation, that person may end up with a tax liability on the appreciation if he or she and those other people who were transferring property in the same transaction do not own at least 80% of the stock of the corporation after the deal is done. Whenever a C Corporation transfers appreciated property to any shareholder, a double tax will likely be triggered — one at the corporate level and a second at the shareholder level. Any contemplated transfer of property between a C Corporation and its shareholders needs to be carefully evaluated to assess potential tax risks of the business.
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