Reconsidering C Corporations
Once considered a last resort for entity choice, C corporations deserve reconsideration, especially surrounding the dreaded double taxation issue.
Double taxation refers to the two levels of taxation that C corporation income goes through. First, the income is taxed at the entity level and then again when the shareholder withdraws any earnings as a dividend. Current tax law puts the top corporate tax rate at 35 percent and the dividend rate at 23.8 percent, making quite a dent. Let’s take a look at an example.
Sample Corporation earns $1 million in income; it pays $350,000 (35 percent) at the corporate tax level, leaving $650,000. Then the sole shareholder takes the entire remaining amount as a dividend, paying another $154,700 in taxes at the individual level, leaving him with $495,300 – or only about 50 percent of the actual income.
So given this, why would anyone choose to operate as a C corporation? Well, for newly forming businesses, there might be two reasons: Section 1202 stock and President Trump’s tax plan.
Corporate Tax Reform Under Trump’s Plan
One of Trump’s signature campaign issues was his position that the 35 percent U.S. corporate tax rate is too high; he proposed dropping it to 15 percent. In combination with this tax cut, he also has proposed eliminating the 3.8 percent net investment income tax and lowering the top dividend rate to 20 percent. You can see the obvious difference before even running the numbers, but let’s look at our prior example to see exactly how this would shake out.
Trump’s plan passes, and Sample Corporation earns $1 million and now pays $150,000 (15 percent) at the corporate tax level, leaving $850,000. Then the sole shareholder takes the remaining amount as a dividend and pays another $170,000 in taxes at the individual level, leaving him with $680,000. Sound great? Well, we need to compare apples to apples. How do C corporations stack up if Trump also cuts the tax rate on S corporations and partnership income?
Trump’s campaign promise was to lower all business income taxes to the 15 percent rate, requiring a divergence from the current law no longer taxing partnerships and S corporations at individual tax rates as pass-through income. If this is the case, the member in an LLC or the shareholder in an S corporation would pay only $150,000 on the same $1 million in income that our C corporation shareholder paid under Trump’s new plan. In the end, this means there is still a tax rate spread of 17 percent (32 percent for C corporations versus 15 percent for partnerships and S corporations).
So even with Trump’s proposed changes, C corporations are still at a comparative disadvantage due to double taxation. What could make a difference? To answer that, we need to look at the treatment of Section 1202 stock.
Section 1202 Stock – What is It?
Qualified small business stock is a stock that meets three requirements. First, on the date it is issued, the issuing entity must be a domestic C corporation with total assets of $50 million or less. Second, the acquiring shareholder must acquire the stock directly from the C corporation, not from an existing shareholder. Third, the issuing C corporation must be an “active business.” (These three requirements are much more technical than this; however, the detail is beyond the scope and purpose of this article.)
Section 1202 Stock – How it makes a Difference
The magic happens when you combine the prospective Trump tax cuts with Section 1202 stock. It makes C corporation status an attractive consideration for newly formed entities. Shareholders in C corporations would still pay more in current taxes, but the long-term payoff when you sell can be huge. Let’s look at an example to illustrate.
Under the new tax structure, you set up Sample Corporation as a C corporation with $100,000 of cash and then sell the stock years down the road for $8 million. In this case, you could exclude the entire gain of $7.9 million from taxation at the 20 percent dividend rate, saving you $1.58 million.
If you had an S corporation instead and sold the same business for the same $8 million, you would pay the 20 percent tax on your $7.9 million gain (this assumes you distributed all of your earned income).
As you can see, when you combine the two elements, a C corporation would cost more up front but not as much in the end. So, keep your eyes and ears open to see what happens with corporate tax reform as it might change your decisions going forward.