Early on in my career I was stuck as a practitioner. I thought that all businesses should be S-Corporations. My reasoning was simple, avoidance of Self Employment Tax, and double taxation. Problem is that S-Corporations are restrictive by nature. There are things that you just can’t do with them. For instance you can’t deduct the health insurance for the owner of an S-Corporation, unless they pay Social Security and Medicare on the contribution. Not to mention that if you have a partner you are restricted to only one class of stock. Preferred stock is very attractive for a shareholder. Those holding preferred stock get paid first, when a dividend is declared. Further, with all of the new taxes on individuals, I have a new love for C-Corporations.
When we deal with corporations, limited liability companies, sole-proprietorships, and partnerships we are dealing with tax issues outside of legalities. The income from an S-Corporation, partnerships, limited liability companies taxed as partnerships, and sole-proprietorships, we are dealing with income that passes directly to individual owners. One factor to keep in mind is that limited liability companies are flexible with their taxation. They can be treated as a disregarded regarded entity making them the default classification of a sole-proprietorship. The attraction to LLC’s are the flexibility of the structure. You can have an attorney draw up an operating agreement whereby you have two classes of membership but not nullify your S-Election in doing so. Further LLC’s are flexible in their taxation, unlike a Corporation.
Early in my career I didn’t see the advantages of a C-Corporation. Today the top tax rate of an individual is 39.6 percent. The income that is associated with that tax rate is anything over $400,000 for anyone filing single or head of household, and $450,000 for anyone filing as married. This doesn’t take into account the new Net Investment Tax of 3.8 percent on incomes of $200,000 if you are filing single or head of household, or $250,000 married filing joint. These new factors make C-Corporations more attractive than they used to be.
Under IRC §11 a C-Corporation is subject to the following tax rates:
Over $50,000 but not over $75,000
Over $75,000 but not over $100,000
Over $100,000 but not over $335,000
Over $335,000 but not over $10,000,000
Over $10,000,000 but not over $15,000,000
Over $15,000,000 but not over $18,333,333
Another advantage to operating as a C-Corporation is that C-Corporations are subject to a lower Alternative Minimum Tax (AMT) rate than individuals. The AMT is equal to the excess of the tentative minimum tax over the regular tax. The tentative minimum tax for a corporation is equal to 20 percent of the excess of the alternative minimum taxable income over the $40,000 exemption amount. Conversely, individuals can be subject to AMT as high as 28 percent. Even with the patch that Congress made on AMT for individuals, it is still a ticking time bomb.
Small corporations, as defined in IRC § 56(e), are generally not liable for AMT. If in the first three years of a corporation’s average gross receipts are $5,000,000 or less, then it is considered a small corporation. Small corporations continue to not be liable for AMT as long as its average annual gross receipts are for the prior three year period do not exceed $7,500,000.
The stock in a C-Corporation is usually a capital asset. Because of this, the gain on the sale of the shares in a C Corporation results in a favorable tax treatment. Upon sale, if the stock is small business stock that has been held for more than five years, the shareholder of the stock can exclude 50 percent of the gain from his or her gross income. This tax break ends on December 31, 2013 unless it is extended by Congress.
Small business stock, namely IRC §1244 stock is the kind of stock that you want. The gain on the sale of IRC §1244 stock is capital. What that means is that you pay the favorable tax rate of 15 percent. The loss on IRC §1244 stock is ordinary. That means that you are not stuck with only deducting $3,000 per year until the loss from the sale is recaptured, like other stock sales.
Something else; if you sell IRC §1244 stock and make a gain, you can roll that gain into another corporation with IRC §1244 stock tax free. The rollover has to be within 60 days. It is important to note that this tax break ends December 31.
As a tax accountant, my problem with C-Corporations, historically has been that the income is double-taxed. A C-Corporation pays income tax at the corporate level. When the C-Corporation distributes that same income to its shareholders the shareholders have to pay tax again personally. These dividend distributions are not deductible by the corporation. However, if a shareholder’s personal income is less than $400,000 for a single and head of household individual and $450,000 for married filing jointly the dividends are taxed at 15 percent. No big deal.
Only problem standing in the way. Personal service corporations are C-Corporations that perform most of its services in such fields as health, law, accounting, and consulting. Personal service corporations are taxed at a flat rate of 35 percent. The bottom line is that it wouldn’t be doable for these kinds of companies.
C-Corporations can end their year whenever you want them to. For instance, you can have a C-Corporation with a year end of September. You could do things like operate an S-Corporation that has a calendar year end and in December pay rent over to this fiscal year C-Corporation, which owns your equipment.
Now more than ever you need a tax professional that thinks outside of the box.
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If you have any questions you can email Craig W. Smalley E.A., C.E.P.®, C.T.R.S.®
Admitted to Practice Before the Internal Revenue Service
Certified Estate Planner®
Certified Tax Resolution Specialist®
Author of the books:
- It Starts With an Idea – Tax Tips for Small Businesses
- The Ultimate Real Estate Investor Tax Guide
- The Complete Guide to the New Tax Law – American Taxpayer Relief Act of 2012
- Everything You Wanted to Know about the IRS – Audits, Appeals and Collections
- Tax Avoidance is Legal! The Complete Guide to Individual Income Tax
- The Complete Guide to the Affordable Care Act’s Tax Provisions
- The Complete Guide to Retirement Plans for Small Businesses
- The Complete Guide to Estate, Gift and Trust Taxation
- The Complete Guide to Hiring an Accountant
- The Complete Guide to Subchapter S-Corporations,
- Free Money
All available exclusively on Kindle