All corporations have two concepts in common which can be used to start your business i.e. ease of transfer of ownership and limited liability protection. Unlike partnerships and sole proprietorships corporations allow you as the owner (aka shareholder), to protect your personal assets from lawsuits and business debt collections. In addition, transferring your ownership stake in the company is as easy as selling your company’s stock. Most of the time, you do not need approval from any other shareholders in the business in order to sell your share of the business. Under current tax regulations, there are two different types of corporate structures in the US: the C Corporation (the most basic and accepted way to incorporate) and the S Corporation (has various restrictions and not all the corporations will qualify to be S Corporation). Each has advantages and disadvantages.
There are several potential tax benefits of forming your small business as a C Corporation. Firstly, all salaries paid, including salaries paid to owner/shareholders are tax deductible business expenses. Although there is a tax on the business as a whole, called the corporate tax, the corporate tax rate can potentially be lower than one’s individual tax rate. If the net income/profit (income after all the expenses have been deducted) of your corporation, is $75,000 or less, you can have significant tax savings.
Example: John Doe, is a business man. He has several ventures. He forms John Inc. a C Corporation that, generated $200,000 in revenue in 2012. He paid $100,000 in salaries and had $50,000 in business expenses. As a result, the corporation’s net income is $50,000. The corporate federal tax bracket on the first $50,000 of profits is 15% (this rate is current and is subject to change) therefore the corporation must pay $7,500 in taxes. Had he structured this business as a sole proprietorship or as an LLC/S Corporation/Partnership, John would have had to pay taxes based on his individual tax rate. Presuming John was in the 25% tax bracket on an individual level, thus his federal tax on that 50,000 of income would have been $12,500. As you can see, there would be a significant tax savings by forming a C Corporation i.e. John Inc. received a lower and preferential tax treatment for its profits of only 15%. Thus, the corporation paid only $7,500 in taxes instead of $12,500 that otherwise John would have to pay on the individual level. As a result John saved $5,000 in taxes that he could now use towards buying more equipment, operational costs and other necessary business expenses.
Its well-known – C corporations have the significant disadvantage of “double taxation,” in which the income that a corporation earns is taxed on both the corporate level and on the individual level. On the corporate level, the corporation is responsible for paying federal, state and local taxes on its profits. In addition to that, the individual shareholder that receives dividends (aka profits distribution) from the corporation, must report this dividend as income. The corporation will issue a Form 1099-DIV to the shareholder, which then must be reported on his/her personal income tax return. However, if the owner/shareholder become employee of the corporation and take a salary instead of dividends, this could significantly reduce or eliminate the corporate double tax. Although it might be ideal for the C Corporation to increase shareholders salary so the corporation would have zero profits, the IRS does not allow C corporations to pay excessive salaries to their employees in order to escape paying dividend tax. Therefore, in order to avoid possible penalties and reclassification of salary to dividends one should only allot a reasonable salary. You can consult your CPA or other licensed tax advisor for guidance on what constitutes reasonable salary.
Another tax advantage of the C Corporation is that it allows for the use of a fiscal year instead of the calendar year. The fiscal year election allows the corporation to choose what period it wants to pay taxes for. Although this decision is very hard to change in future years, this provision allows the company to do tax advantages planning during its first year in operation.
Example: In January 2012, John decided to form a C Corporation, John Inc. John knew that based on his current sales projections, he was going to have a very slow sales season in the beginning of the year and large amount of sales in October and thereafter. As a result, John decided to make his fiscal year-end as of September 30th. That way, for 2012 John was able to minimize the corporate taxes by allowing his corporation to pay taxes only on income that was generated during the first part of the year where the corporation would be taxed at the much lower tax bracket. Had he not made this election to have his fiscal year-end in September, the high volume of sales in October would have pushed him into a higher corporate tax bracket, thus John Inc. would be paying taxes at much higher rate for 2012.
A C Corporation is also very beneficial in terms of deductibility of its’ owner’s employee benefits. Medical insurance, medical expenses, disability, life insurance and other fringe benefits are deductible as business expenses. In all other structures these benefits either would not be allowed or would be subject to taxes to the owner.
Under certain situations, a C Corporation can also be a tool for tax savings through income splitting. Please speak to your CPA or qualified tax adviser for more information as to how this tax planning tool can potentially provide your company with significant tax savings.
In addition to all of these tax savings possibilities, there are also other considerations for choosing to form your business as a C corporation. Firstly, filing as a C Corporation allows a business to be able to raise significant capital by issuing stock to large numbers of shareholders. A C Corporation can have foreign or non-resident shareholders. A C Corporation also is not limited to the amount of shareholders that it may have, unlike in an S Corporation where only US citizen and resident taxpayers can be shareholders and a maximum of 100 shareholders is allowed. For these reasons, most large international corporations chose to incorporate as C Corporations. Finally, from an audit risk perspective, C Corporations under 500K in revenue, have the benefit of generally having a lower risk of being audited than an S Corporation, LLC or Sole-Proprietorship.
Note that, the C Corporation is formed under individual state laws. Often the state tax laws do not conform to the federal tax laws. This is another reason why it is important to consult with an experienced tax accountant or CPA who will properly advise you on all tax and corporate related matters.
If you require any assistance from our team of experienced CPAs and tax accountants, please do not hesitate to contact us, we will be happy to help you structure your business property so it can provide you with maximum tax savings.
This article was written by TaxBizPro, LLC 2012, all rights reserved ©.