THE C-CORPORATION VS. PASS-THROUGH ENTITIES
The C-Corporation is frequently disregarded as an option for small business entrepreneurs. This is often for good reason. The threat of being taxed at both the corporate level and at the shareholder level, known as double taxation, as well as being required to follow more formalities, such as an annual shareholder meeting, are enough to give small-business entrepreneurs pause.
“Pass-through entities,” on the other hand, are typically favored by small-business entrepreneurs because they are not taxed at the entity level, but are taxed on the shareholders’ personal return, so there is only one level of taxation. This effectively avoids the double taxation that is characteristic of the C-Corporation. Additionally, pass-through entities often have more lenient formalities.[1]
Despite these typically favored aspects of pass-through entities, there are situations where a C-Corporation may be the most advantageous entity option. What follows are some benefits that are unique to C Corporations that small-business entrepreneurs should consider when deciding between entities.
These are merely additional factors for consideration and are in no way determinative of a particular entity choice. Please contact a qualified professional before making a final decision.
§1202 GAIN EXCLUSION
26 U.S.C. §1202 allows a taxpayer to exclude from their
federal tax bill the gain on the sale of qualified small business stock. While
gains from the sale of stock in S-Corporations or of membership units in an LLC
or Partnership are taxed, gains from the sale of stock in C-Corporations can be
tax-free.[2]
This exclusion only applies to stock in C-Corporations and serves two purposes. The first is to provide founders of small businesses with a tax benefit, while simultaneously making the C-Corporation a more desirable entity for small-business entrepreneurs. Under §1202, founders of C-Corporations who purchase their stock from the corporation can have significant tax savings upon the sale of their stock, as compared to other entity types. The second purpose is to encourage investment in small businesses. Non-founder investors can also benefit from this tax break, meaning that small-business C-Corporations may be more appealing to investors because such a tax break is unavailable in other entity forms.
Therefore, the §1202 exclusion may be of special benefit to entrepreneurs who are looking for additional funding, as well as for those who intend to start small, pay limited dividends, and cash out at some point.
Re-Investing in the Business
One major difference between a C-Corporation and
pass-through entities (such as the S Corporation and LLC) is that owners of
pass-through entities are taxed on their distributive share of the business
income, regardless of whether or not
they actually receive a distribution from the business. This differs from a
C-Corporation, where earnings retained for re-investment in the company are not taxed.
For example, if the owner of an LLC wanted to reinvest funds into their business, the business profits would be taxed at ordinary income rates before being re-invested in the company; conversely, the owner of a C-Corporation will generally not be taxed on such re-investment. For small-business entrepreneurs who aim to grow the business from the start and to keep dividends small, this can be a significant tax break.
Fringe Benefits
C-Corporations have generous deductions for fringe benefits,
such as for premiums paid for disability insurance and health insurance,
childcare assistance programs, and certain meals, lodging, and transportation.
Although some deductions are available to pass-through entities, the number of
deductions and percent deductible for fringe benefits favors the C-Corporation.
Current vs. Historical Tax Treatment
Ordinary income tax rates are currently low, increasing the appeal of pass-through entities; but there are two immediate problems with this. The first is that, while rates are currently low, they are historically low.[3], [4], [5] Coupled with a national debt that is growing at a seemingly exponential rate, ordinary tax rates are likely to increase in the near future. The potential for increased tax rates means that the tax advantages currently available to pass-through entities may not be as beneficial in the future.
Historical Tax Rates
|
Decade |
Range of Highest Ordinary Tax Rate |
Range of Lowest Ordinary Tax Rate |
Range of Highest Capital Gain Rate |
|
1950s |
84.36 - 92% |
17.4% - 22.2% |
25% - 26% |
|
1960s |
70% - 91% |
14% - 20% |
25% - 27.5% |
|
1970s |
70% - 71.75% |
14% |
30.2% - 35% |
|
1980s |
28% - 70% |
11% - 15% |
20% - 28% |
|
1990s |
28% - 39.6% |
15% |
20% - 28% |
|
2000s |
35% - 39.6% |
10% - 15% |
15% - 20% |
|
2010s |
35% - 39.6% |
10% |
15% - 20% |
|
2020s |
37% |
10% |
20% |
Despite the likelihood of individual ordinary rates
increasing, the corporate rates typically do
not significantly change. This is partially due to the concern that
corporate tax rates may simply be passed onto consumers, which would impose a
sort of implicit tax on them. In fact, corporate rates across the world have
declined over the past few years, resulting in a “race to the bottom” that
would be difficult for countries to reverse without significant repercussions
to business in their territories.[7]
While this is a big picture view of the U.S. tax system, it has a significant impact on small business owners. If ordinary tax rates rise in the future while the corporate and capital gains rates stay relatively stable, the tax benefits provided by pass-through entities would be substantially reduced. In this scenario, owners of a pass-through entity would be taxed at high ordinary rates, whereas, owners of a C-Corporation would be taxed at lower corporate and capital gains rates. For owners of C-Corporations, this could result in after-tax returns that are comparable to those of pass-through entities. This would make the previously discussed C-Corporation benefits even more appealing.
Bonus Tip: Avoiding Double Taxation
One method for avoiding double taxation in a C-Corporation
is by paying employee-owners a salary rather than a dividend. Salary payments
are deductible, whereas distribution of dividends are taxed.
Although an individual’s ordinary income rate is higher than the capital gains rate that would have applied had they been paid a dividend, the employee-owner avoids the corporate tax rate and receives the same tax treatment as a pass-through entity.
Conclusion
Although the C-Corporation is an often overlooked entity
option for small-business entrepreneurs, there are several reasons to consider
a C-Corporation: (i) §1202 exclusion for sale of qualified small business stock
(ii) non-taxed business reinvestment (iii) deductible fringe benefits (iv)
historically low capital gains rates and the likelihood of ordinary rates to
rise and (v) tactics to keep non-deductible dividends low, such as paying
employee-owners a salary. Pass-through entities are frequently the right
choice, but these benefits can make the C-Corporation the more advantageous
entity option for various small-business entrepreneurs.
[1]
One type of pass-through entity that may actually have more requirements than
those of a C-Corporation is an S-Corporation. This may be particularly true
when it comes to who can be a shareholder of an S-Corporation versus ownership
in a C-Corporation.
[2] 26 U.S.C. §1202 has several requirements, such as a
5-year holding period, eligible shareholders, and cap on gain that can be
excluded, among others.