09 Dec C-Corporation Tax Traps
There ere are some tax traps that a C Corporation needs to monitor and hopefully avoid. The C Corporation double tax structure produces more revenue for the government when larger dividends are paid and less income is accumulated inside the corporation. For this reason, there is a separate penalty tax called the “Accumulated Earnings Tax” that is imposed on any C Corporation that accumulates too much of its earnings.
The current penalty rate is the same as the maximum rate on dividends. The tax doesn’t kick in until the aggregate accumulated earnings of the corporation exceed $250,000, and that threshold limit is reduced to $150,000 in the case of certain professional service organizations. And this penalty can be avoided completely if the corporation can demonstrate that had accumulated the earnings in order to meet the reasonable needs of the business.
If earnings above the statutory thresholds, 250,000 or 150,000, as the case may be, are being exceeded, what is needed is an annual resolution of the corporate directors ideally supported by a numbers analysis that spells out why the income accumulations are necessary to meet the reasonable needs of the business.
There’s a great deal of latitude in defining reasonable business needs. For these reasons, the accumulated earnings penalty usually is a trap for the uninformed that just didn’t see it coming. It’s usually just a nuisance that has to be watched as good things start to happen inside a C Corporation.
The second penalty trap called the “personal holding company tax” is a closed cousin to the accumulated earnings trap. Its purpose is to prohibit C Corporations from accumulating excess amounts of investment income, rental income, and compensation payments realized through an incorporated personal talent such as a movie star or a pro athlete.
The penalty rate is the same as the maximum rate on corporate dividends. If this penalty becomes a threat, remedial actions include increasing compensation payments to the shareholders who work in the company or paying dividends. Like the accumulated earnings tax, it’s a nuisance that has to be monitored in select situations.
The next trap is the “alternative minimum tax” which might apply to large C Corporations. There are blanket exemptions for a company’s first year of operations. Any company with average annual gross receipts of not more than $5,000,000 during its first 3 years, and any company with average annual gross receipts of not more than $7,500,000 following the first 3-year period.
So, small C-Corporations don’t need to worry about this tax. The tax applies only to the extent that exceeds the corporation’s regular income tax liability. The taxes calculated by applying 20% rate to the excess of the corporation’s alternative minimum taxable income over a $40,000 exemption. The greatest impact in recent years has been an expansion of the alternative minimum taxable income definition to include an amount which roughly speaking equals 75% of the excess of the corporation’s true book earnings over its taxable income.
The last trap mentioned here is the “controlled group trap” — a trap targeted at the business owner who would like to use multiple C Corporations to take multiple advantage of the low C Corporation tax rates, the $250,000 accumulated earnings tax threshold or the $40,000 alternative minimum tax exemption. For example, absent this trap: $500,000 of annual corporate earnings could be spread among 10 C Corporations that would be $50,000 each at a 15% tax rate applied to each of the corporations.
If multiple corporations are deemed to be part of a controlled group, they are all treated as a single entity for purposes of these tax perks and the multiple benefits of a C corp are gone.
There are three types of controlled groups. Whenever C Corporation shareholders own or control multiple C-Corporations, this trap can be a problem. So the planning process for any new C-Corporation must include an effort to identify and assess the impact of other C Corporation interests owned by those who are going to be the shareholders of the new company.