May 14/21, 2018: Volume 33, Issue 24
By Roman Basi
In one of my previous articles, I focused primarily on the Tax Cuts and Jobs Act’s (TCJA) impact on pass-through entities: sole proprietorships, limited liability companies (LLCs) taxed as partnerships or S corporations. In this installment, I provide an analysis of the other corporate form, C corporations.
While an S corporation election can be beneficial for many businesses, don’t discount a C corporation’s 21% flat tax rate or let the fears of double taxation haunt your entity election. With the right advice, you can reduce (if not avoid) double taxation.
For guidance, see the chart below, which provides a comparison between pass-through entities and C corporations. Notice in the “comparison” column there is a $13,650 tax savings under a pass-through entity. If the analysis stopped here, every business owner would elect a pass-through entity. However, it is important to further analyze the comparisons as the complexities extend beyond what is provided in the numbers herein.
There are three important aspects to consider when analyzing whether a C corporation election is best for your business. In most small business C corporations, the shareholders also act as employees. Generally, there are two methods to allocate compensation to these shareholders. First, in the form of a qualified dividend subject to a distribution tax with a maximum tax rate of 20% (23.8% if subject to the net investment income tax). Additionally, the qualified dividend is a non-deductible, after-tax profit distribution to the corporation. Thus, a qualified dividend of $100,000 will be taxed at the 21% corporate rate and 15% distribution rate resulting in the highest tax burden of $32,850.
A second method of compensation is payment for services rendered in the shareholder’s capacity as an employee. In this scenario, compensation is only taxed at the individual level to the shareholder/employee and is deductible to the corporation, thus avoiding the prospect of double taxation.
The issue here is the compensation must be reasonably related to the services rendered. The interplay between compensation and the number of employees should be a focus of your tax analysis when determining whether to elect C corporation or pass-through entity status.
Moreover, if investment or expansion are part of your business model, a C corporation can retain its earnings tax free so long as it can provide proof of expansion or investment. However, retained earnings can become subject to taxation, as the IRS promotes policies of providing compensation or issuing qualified dividends.
This article just scratches the surface in the comparison between C corporations and pass-through entities. A number of other factors must be analyzed to determine the best path for your business.