The majority of small businesses in the U.S. are pass-through entities, i.e. sole
proprietorships, partnerships, Limited Liability Companies (LLCs) and S corporations (S corps). This means their profits are ‘passed through’ to the owners and shareholders, who then report business income or losses on their personal tax returns. Pass-through entities are not required to pay corporate taxes. Under the Tax Cuts & Jobs Act (TCJA), pass-through entities may be able to qualify for a 20 percent deduction on taxes due for pass-through income. For example, if a small business has $100,000 in income that will be passed through, only $80,000 of that would be taxable under the new tax law.
On the contrary, a C corporation (C corp) is not a pass-through entity and is completely separate from its owners when it comes to taxes. Earnings are taxed at the corporate level, and any dividends distributed to shareholders are also taxed at their personal level. In the past, many businesses opted for an S corp structure to avoid the ‘double taxation’.
However, there are a bevy of tax benefits available to C corps that can lessen or even prevent double taxation. What’s more, many business owners are reconsidering their corporate structure in light of the new tax reform, which significantly reduces the tax burden on C corps. Under the new tax bill, the corporate tax rate for C corps decreased from 35 percent to 21 percent, which is lower than the tax rate for pass-through income. Furthermore, as a result of the decrease in most individual tax brackets, even income that is passed-through to individual shareholders will be taxed at a lower rate. Given both of these reasons, there are now less tax advantages to filing your business as a pass-through entity vs. a C corp.
What Are the New Tax Advantages of C corps?
Beyond the new corporate tax rate, there are many reasons businesses can benefit from having a C corp structure, regardless of the company’s size, including:
1. Minimizing your overall tax burden.
C corps were the biggest winners under the TCJA. The new corporate tax rate of 21 percent can mean significant tax savings, especially if a business doesn’t regularly make distributions to owners in the form of dividends. If business owners are only taking a salary, that amount is not taxed at the corporate rate — shifting the tax equation further in their favor. Not taking a dividend often makes sense for new or small businesses where the money is being reinvested into growing operations.
2. Carrying profits and losses forward and backward.
Whereas the fiscal year must coincide with the calendar year for LLCs and S corps, C corps can benefit from having more flexibility in determining their fiscal year. Shareholders can shift income more easily, deciding what year to pay taxes on bonuses and when to take losses, which can substantially reduce tax bills.
3. Accumulating funds for future expansion at a lower tax cost.
The C corp model allows shareholders to shift income readily and retain earnings within the company for future growth, usually at a lower cost than for pass-through entities (profits from S corporations appear on shareholders’ tax returns whether they have taken a distribution or not).
4. Writing off salaries and bonuses.
Shareholders of C corps can serve as salaried employees. While these salaries and bonuses fall subject to payroll taxes and Social Security and Medicare contributions, the corporation can fully deduct its share of payroll taxes. Moreover, the company can pay employees enough so that no taxable profits remain at the end of the fiscal year (within reason, of course; the IRS does check that the salaries correspond to the services that shareholders provide as employees). Shareholders frequently use this option rather than receive dividends, which would indeed be taxed twice.
5. Deducting 100 percent of medical premiums and other fringe benefits.
As long as the company makes fringe benefits equally available to all employees, not just shareholders, there are many significant tax write-offs possible for a C corp that individual employees also receive tax free: medical reimbursement plans and premiums for health care, long-term care and disability insurance. With S corps, shareholders deduct medical costs from gross income but have to declare these same fringe benefits as income.
6. Writing off charitable contributions.
C corps are the only kind of corporate entity that can deduct contributions (not more than 10 percent of taxable income in any given year) to eligible charities as a business expense. You can carry over charitable donations above the limit to the next five tax years, too.
7. Carrying losses over multiple years.
This business structure can take large capital and operating losses. This is especially important for start-ups that may take substantial losses in the first year but wish to carry them forward to future years.
8. Enjoying fewer ownership restrictions than S corps.
S corps have numerous rules limiting ownership: no more than 100 shareholders, no non-resident alien owners and no non-individual owners (with few exceptions), for starters. They also may not issue more than one class of stock. If your company is seeking equity investors, these limitations may present a challenge.
9. Encouraging passive investors.
One much-lauded advantage of S corps is the ability to pass losses through to individual tax returns. However, this only applies to shareholders who participate actively in the management of the corporation. Thus, passive investors tend to fare better tax-wise under C corps.
10. Attracting financing and going public.
Venture capitalists prefer the flexible ownership of the C corp business structure, and some forms of small business financing are only open to C corps. One of the less-often talked about, yet financially significant advantages of the C corp structure is that it’s the only entity that supports 401(k) business financing (formally called the Rollovers for Business Start-ups (ROBS) arrangement.) ROBS allows entrepreneurs to use their retirement funds as business financing without incurring tax penalties or early withdrawal fees. Because C corps are the only entity that allows selling stock ownership for cash, they’re the only structure that supports the ROBS arrangement. Furthermore, if your business is considering becoming a publicly traded company on a national stock exchange, it must have a C corp structure, as well.
In summary, given the TCJA, C corps are proving to be more beneficial for some businesses. Selecting a corporate structure isn’t a decision to take lightly, and as businesses grow and evolve, owners may need to change their structure. The C corp model isn’t only for large organizations; small companies can benefit greatly from the potential small business tax deductions, and they may mitigate the effects of double taxation.
Business owners should always consult with a tax professional and prepare to assess and possibly adjust their organizational strategy. Please contact Restivo Monacelli as soon as possible to discuss your particular situation. We will help you to determine what entity structure will provide you the maximum tax benefits under the TCJA.