How are corporations taxed?
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 it 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.
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 are more than $10 million, the rate jumps to 35%. And there’s 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 earnings 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 reduced 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 are due to expire at the end of 2012. At this point, it’s anyone’s guess what Congress will do starting in 2013. 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 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 the 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 doublet 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 million and that its tax basis and the assets sold is $2 million. The corporation would pay a federal income tax of 34% on the $3 million 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 million. 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 in 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 to family members; personal shareholders’ 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 rendered 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 and percentage change requirements may trigger taxable dividends.
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. In a 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, Linda, who purchased her stock for $100,000 and that the company has accumulated and invested $2 million of earnings over the last ten years. Linda’s stock basis at the end of year ten would still be $100,000. As we will see, if the company had been taxed as an S Corporation from day one, Linda’s basis in her stock at the end of year ten would have gone to $2.1 million. So on a sale of the stock, Linda would end up paying a capital gains tax on an extra $2 million 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 are 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. A C Corporation may participate in tax-free reorganizations with other corporate entities. It’s possible for corporations to combine through mergers, stock-for-stock transactions, and asset-for-stock transactions on terms that eliminate all corporate and shareholder level taxes. This perk often is the key to the ultimate payday for those private business owners who want to cash in by selling their business to a public corporation. Cast as a reorganization, the transaction allows the corporate buyer to fund the acquisition with its own stock usually paying little or no cash and enables the selling owners to walk from the deal with a highly liquid, publicly traded security and no tax bills until those securities are actually sold.
A non-corporate entity, an LLC or a partnership, cannot participate in this type of tax-free corporate reorganization. A shareholder of a C Corporation who is also an employee of the company may participate in all employee benefit plans and receive the same tax benefits as other employees of the company. Such plans typically include group term life insurance plans, uninsured medical and dental reimbursement plans, cafeteria plans, healthcare assistant programs and qualified transportation reimbursement programs.
Most S Corporation shareholders, those who own more than 2% of the outstanding stock of the company, are not eligible for the tax benefits associated with these types of employee benefit plans. This factor alone makes the C Corporation an attractive option for many businesses where the owners work full time for the company.
There are also potential tax benefits when a shareholder sells stock of a C Corporation. Stock of a corporation is a capital asset that qualifies for long-term capital gain treatment if sold after being held for more than 1 year. This capital gains benefit has been a big deal in the recent past because the maximum capital gain rate has been only 15 percent. The problem for planning purposes is that it is usually difficult, if not impossible, to accurately predict when the stock may be sold and even more difficult to speculate on what the state of the long-term capital gains break will be at that time.
Just over the last three decades, we have seen the gap between ordinary and capital gains rates completely eliminated, narrowed to levels that were not compelling for planning purposes, and has now lightened to levels that gets everyone excited. The capital gains tax has always been a political football and we have no reason to believe that that reality will ever change. Many powerful forces viewed as nothing more than a sop to big business and the rich while others passionately label it an essential element of a strong and vibrant economy. The current 15% maximum rate is due to expire at the end of 2012. After that, who knows?
Another potential C Corporation stock sale break is found in Section 1045 which permits an individual to defer the recognition of gain on the sale of qualified small business stock held for more than 6 months by investing the sales proceeds into the stock of another qualified small business within 60 days following the sale.
Generally, stock will meet the qualified small business stock definition if the stock was issued to the selling shareholder as the original issuee after the effective date of the revenue reconciliation act of 1993 by a C Corporation that actively conducts a trader business and that had gross assets of $15 million or less at the time the stock was issued. This perk can excite the entrepreneur who is in the business of moving money from one deal to the next or the shareholder who has a falling out with his or her co-shareholders and wants to exit for another investment opportunity.
A third potential C Corp sellout perk is found in Section 1202. In the past, this provision has allowed an individual shareholder to exclude 50% and for a limited time, 75% of the gain recognized on the sale or exchange of qualifying small business stock held for more than 5 years. Although it sounds good on its phase, the perk never got too many excited because the taxable portion of the gain was subject to a high 28% capital gains rate and the tax break could trigger or enhance an alternative minimum tax problem.
So often this perk was ignored for planning purposes. Congressional action gave this perk a huge shot in the arm by increasing the exclusion to 100% and eliminating the alternative minimum tax risks for stock bought between September 27, 2010 and January 1, 2012. If this mammoth change is extended by Congress beyond 2011, it could become a big factor in any change of entity analysis because it eliminates all of the negatives of the old section 1202 and removes one of the biggest C Corporation traps for many businesses – a double tax at time of sale.
Unlike an S Corporation, a C Corporation may freely adopt any fiscal year to ease its accounting and administrative burdens, and to maximize tax deferral planning opportunities for those shareholders who were employed by the company. No special showing is required and there are no special deferral limitations. This benefit is not available to professional service organizations that are taxed as C Corporations.
If stock of a small C Corporation is sold at a loss, there may be a tax break under section 1244. That section grants ordinary loss treatment as opposed to less favorable capital loss treatment on losses recognized on the sale or exchange of common or preferred stock of a small business corporation.
Now, basically that’s defined as a C Corporation whose aggregate contributions to capital and paid in surplus do not exceed $1 million. In order to qualify, the shareholder must be the original issue of the stock and the stock must have been issued for money or property. Also, this perk usually sounds better than it really is. The problem is that the ordinary loss in any single year is limited to $50,000. It’s increased to $100,000 for a married couple. This serious dollar limitation coupled with the fact that bailout loss treatment is not an exciting topic during the startup planning of any business usually results in this perk having no impact in the planning process.
C Corporations also may have offspring. Often it is advantageous to use multiple corporations to conduct the operations of an expanding business. Multiple entities can limit liability exposure, regulatory hassles, and employee challenges as operations diversify and expand into multiple states and foreign countries. While there may be compelling business reasons for the use of multiple entities, business owners often prefer that all of the entities be treated as a single entity for tax purposes in order to simplify tax compliance to eliminate tax issues on transactions between the entities and to facilitate the netting of profits and losses for tax purposes.
All this is possible with multiple C Corporations under the consolidated return provisions of the Internal Revenue Code. The key is to ensure that the entities constitute an affiliated group which generally means that their common ownership must extend to 80% of the total voting power and 80% of the total stock value of each entity included in the group.
There’s also an attractive income tax deduction for dividends paid by one C Corporation to another C Corporation. The purpose of the deduction is to eliminate a triple tax on corporate earnings attributable to C Corporation stock held by another C Corporation. The deduction is at least 70% and increases to 80% for corporate shareholders that own 20% of the operating entity’s stock and to 100% for 80% owners that are part of an affiliated group. There are special anti-abuse provisions that need to be monitored when this deduction is in play. This perk is important in those situations where all or a significant portion of a company’s stock is going to be owned by other C Corporations.
Finally, there 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’s 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.
Now 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 it 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 is 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 close 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 start 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 million during its first three years and any company with average annual gross receipts of not more than $7.5 million 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 it exceeds the corporation’s regular income tax liability. The tax is calculated by applying a 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 in 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 control 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 a part of a controlled group, they are all treated as a single entity for purposes of these tax perks and the multiple benefits are gone.
There are 3 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.
Let’s shift our focus now to S Corporations. S Corporations and their shareholders are taxed very differently, but not every corporation is eligible to elect S status. If a corporation has a shareholder that is a corporation, a partnership, a nonresident alien, or an ineligible trust, S status just is not available. Banks and insurance companies cannot elect S status. Also, the election cannot be made if the corporation has more than 100 shareholders or has more than 1 class of stock.
For purposes of the 100 limitation, a husband and wife are counted as only 1 shareholder and all the members of a family, 6 generations deep, may elect to be treated as a single shareholder. The one class of stock requirement is not violated if the corporation has both voting and nonvoting common stock. And the only difference between the two stocks is voting rights. But all preferred stock is out. Also, there’s a great, a really huge safe harbor provision that easily can be satisfied to protect against the threat of an S selection being jeopardized by a shareholder debt obligation being characterized as a second class of stock.
In defining the S status eligibility rules, Congress has expanded the rules for trusts overtime. Many commonly used trusts are now eligible to be S Corporation shareholders including a voting trust, irrevocable living trust, select trust that receive S Corporation stock via a will or a living trust when somebody dies, a QTIP trust, and a special trust called an electing small business trust. But this eligible trust list is still very limited and many trusts used in estate planning will not qualify as S Corporation shareholders. So whenever an S selection is part of a plan that involves trusts and, as many do, great care must be taken to ensure that the S status is not inadvertently lost because an ineligible trust ends up owning some of the stock of the S Corporation.
Electing in and out of S status can present some planning challenges. An election to S status requires the consent of all shareholders. A single dissenter can hold up the show. For this reason, often it is advisable to include in the organizational agreement among the owners, typically a shareholders’ agreement, a provision that requires all owners to consent to an S election if a designated percentage of the owners at any time approves the making of the election. Exiting out of S status is easier than electing in. A revocation is valid if approved by shareholders owning more than half of the outstanding voting and nonvoting stock.
The income of an S Corporation is passed through and taxed to its shareholders. The corporate entity itself reports the income but generally pays no taxes. Plus, the corporate entity must report to the shareholders specific items that a shareholder will report differently on a personal income tax return items such as capital gains or interest expense, charitable contributions and similar items. These are referred to as separately stated items. The advantage, of course, of this pass-through structure is that there is no threat of a double tax. There is only one tax at the owner level.
Since there is no double tax threat, all of the C Corporation traps tied to that menacing double tax structure are no longer needed. Things such as disguised dividend trap or the accumulated earnings trap or the personal holding company trap and the alternative minimum tax trap.
S Corporation losses also are passed through to the shareholders. Unlike a C Corporation, the losses are not trapped inside the entity. Does this mean the shareholders can use the losses to reduce the tax bite on their other income? Maybe. There are various hurdles that must be overcome at the individual shareholder level and they can be difficult in many situations. An S Corporation shareholder, for example, cannot benefit from any loss to the extent it exceeds the shareholders’ out-of-pocket investment in the stock of the company or loans made by the shareholder to the company.
Perhaps the toughest hurdle is the passive loss rule, an 80’s brainchild that is designed to prevent a taxpayer from using losses from a passive business venture to offset active business income or portfolio income – portfolio income being interest dividends, that type of thing. It was created to stop doctors and others from using losses from real estate and other tax shelters to reduce or eliminate the tax on their professional or investment income. Losses passed through from a passive venture can only be offset against passive income from another source. If there is not sufficient passive income to cover the passive losses, the excess passive losses are carried forward until sufficient passive income is generated or the owner disposes of his or her interest in the passive activity that produced the unused losses.
Whether a particular business activity is deemed passive or active with respect to a specific S Corporation shareholder is based on the shareholder’s level of participation in the entity. That is, whether the shareholder is a material participant in the activity. Generally speaking, and I do mean generally, the material participation standard will be met if the shareholder works more than 500 hours in the business during a given year or spends more time working in the business than any other person.
Given this hurdle in any planning analysis, it is never safe to assume the use of the S Corporation will convert startup losses into slam dunk tax benefits for the shareholders. As a pass through entity, an S Corporation has the potential to generate passive income for its shareholders. That’s a very good thing. Generally, taxable income is classified as portfolio income which is dividends, interests, royalties, that type of thing.
Active income, which is income from activities, in which a taxpayer materially participates or passive income, income from passive business ventures operated through an S Corporation or a partnership tax entity. Passive income is the only type of income that can be sheltered by either an active loss or a passive loss. So the passive loss rule, by the limiting the use of passive losses, exalts the value of the passive income. An S Corporation that generates passive income can breathe tax life into passive losses from other activities. A C Corporation has no capacity to produce passive income. It pays dividends or interests both classified as portfolio income or compensation income which is classified as active income.
In contrast, an S Corporation may pass through valuable passive income to those who do not work for the company. An S Corporation’s shareholder basis in his or her stock fluctuates. Unlike stock in a C Corporation, there is no lock-in basis. When income is allocated to the shareholder, the stock basis goes up. When losses are allocated and cash or property is distributed, the stock basis goes down. This basis booster can be a valuable perk to the owner of a thriving business that is retaining income to increase growth and expansion.
In the case of Linda previously discussed, the $2 million of retained earnings in an S Corporation would have increased the basis of her stock by that $2 million. An S Corporation offers a few of the same perks as a C Corporation. An S Corporation may enjoy all the benefits of the tax-free reorganization provisions of the code. And the sale of S Corporation stock will trigger capital gains treatment. An S Corporation may even have a multi-entity holding company structure by an S Corporation creating qualified subchapter S subsidiaries.
Transfers of appreciated property between an S Corporation and its shareholders might trigger unpleasant tax consequences, so they need to be carefully analyzed. If for example appreciated property is exchanged for stock, the same 80% stock control requirement previously mentioned for C Corporations will need to be satisfied to avoid a tax hit for the shareholder. And if an S Corporation transfers appreciated property to its shareholders, a tax hit will be triggered but not the painful double tax of a C Corporation tax structure.
Also, any liquidating distributions or redemptions may trigger tax liabilities with an S Corporation. An S Corporation like a partnership tax entity is subject to severe limitations in selecting a fiscal year. Hence, nearly all S Corporations are calendar year taxpayers. As compared to a C Corporation, there is much less flexibility on this one. A C Corporation’s conversion to an S Corporation is far easier from a tax perspective than a conversion to an entity that is taxed as a partnership. Usually, such a conversion is the only viable option for a C Corporation that wants to shed its C status and become a pass through entity. But there are some traps in an S Corporation for built-in gains, prior accumulated C Corporation earnings, LIFO inventory reserves, and excessive S Corporation investment income. But usually, these traps can be mitigated or eliminated completely with smart planning.
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