Most small businesses organize themselves into S-Corporations. The obvious reason for doing so would be the avoidance of double taxation. However, there are some good reasons to elect to be taxed as a C-Corporation.
C-Corporations lower tax rates on its first $75,000 of taxable income, versus the shareholders’ top marginal rates.
Use of a C-Corporation to write off potential itemized deductions.
Use of a C-Corporation to write off shareholder fringe benefits.
Unique C corporate pros and cons such as unreasonable compensation.
Development of an exit strategy to avoid C-Corporation double taxation.
C-Corporation nontax advantages.
For many closely held businesses, it is possible to drain off essentially all of the taxable income of a C-Corporation by paying salaries and benefits to the shareholders/employees. In operation, thus, many small C-Corporations actually work like S-Corporations (i.e., the corporation does not pay any tax because its earnings are taxed to the shareholders). However, it may be wiser to leave some corporate earnings in the corporation instead of wiping them out completely by paying bonuses to the shareholder/employees.
A C-Corporation’s marginal tax rate jumps from roughly 18% to 39%, as taxable income goes from $75,000 to $335,000. The C-Corporation marginal rate then drops to 34% as taxable income climbs to $10 million, and finally levels off at 35% for corporate taxable income in excess of $18,333,333. The C-Corporation sweet spot is up to the $75,000 of taxable income mark. The corporate/individual rate differential shrinks significantly after that point.
Even for taxable income above $75,000, the C-Corporation rates compare favorably to the individual rates-especially at relatively high levels of taxable income for which the individual rate is 39.6% in 2014 and the C-Corporation rate may be only 34%. Thus, when the primary concern is to minimize current taxes so that the maximum amount can be retained in the business for an indefinite period, the C-Corporation may be a good choice despite the existence of the double taxation problem.
Comparing corporate to individual rates becomes harder as taxable income increases. While the corporate marginal rate settles down at 34% at the $335,000 taxable income mark, figuring the individual marginal rate gets very problematic as larger amounts of taxable income start wiping out more itemized deductions and exemptions. Depending on the client’s specific individual profile, such as married or single, larger amounts of additional taxable income can raise the effective marginal rate by several percentage points due to phase out of deductions. One practice tip is to prepare a hypothetical individual return for the client’s specific profile, using various income levels, and then compare the individual results to an analogous hypothetical corporate return.
Often, the deciding factor in choosing a business form is the impact of state and local income taxes. Even though state and local income taxes are deductible against federal taxable income, the net tax cost can still be significant.
Using a C-Corporation to Write Off Shareholder Fringe Benefits
Fringe benefits are noncash consideration provided to employees that are deductible by the employer and, in some cases, nontaxable to the employee. Under IRC Sec. 61, employees must include the value of fringe benefits in their taxable income unless specifically excluded by another provision of the Code. For this discussion, tax-advantaged fringe benefits mean those that the corporation can deduct and the employees can exclude from taxable income. The point here is that fringe benefits for shareholder/employees of C-Corporations are fully deductible by the corporation, while most fringe benefits paid for owner/employees of S-Corporations and partnerships are, for all practical purposes, nondeductible. Thus, deducting shareholder/employee fringe benefits is a significant advantage of the C-Corporation form.
Tax-advantaged fringe benefits are subject to a number of qualification and reporting requirements that are beyond the scope of this Guide. Practitioners without significant fringe benefits expertise may wish to bring in a competent employee benefits expert and review PPC’s Guide to Compensation and Benefits to help in providing guidance in establishing fringe benefit programs.
Accident and Health Plans
Accident and health plans provide benefits to employees when they are ill or injured. Such plans may also cover employees’ spouses and dependents and retired employees. The most common types of accident and health plans are insured major medical plans and insured dental plans. Long-term care insurance is generally treated as accident and health insurance as well. With insured plans, the employer pays premiums to an insurance company, which then pays covered expenses directly to care providers or reimburses employees for such expenses. Also relatively common are uninsured medical expense reimbursement plans listed at https://creditrepaircompanies.com/medical-debt/. These reimbursement plans provide direct payments to employees for covered expenses.
The contributions of a C-Corporation employer (via payment of insurance premiums or otherwise) to employee accident and health plans generally are deductible even though some of the employees are also shareholders. On the employee side, the employer contributions to insured plans as well as direct payments received from insured and uninsured plans normally are not included in the employee’s taxable income.
If certain nondiscrimination rules are met, the cost of employer-provided group-term life insurance coverage of up to $50,000 can be excluded from the employee’s taxable income. This is true even though the C-Corporation employer can deduct the cost of the insurance premiums. If the employer-provided coverage exceeds $50,000, the employee will have taxable income equal to an amount determined by IRS tables.
Under IRC §129, a C-Corporation employer can deduct the cost of a qualified dependent care assistance plan. Employees can exclude from taxable income up to $5,000 per year ($2,500 for married filing separate status) of the value of this benefit as long as the cost is considered employment related for purposes of the child and dependent care credit under IRC §21.
For closely held businesses, probably the biggest stumbling block in meeting the definition of a qualified dependent care assistance plan is the requirement that no more than 25% of the cost paid by the employer be for employees who are also more than 5% shareholders of the employer corporation. This rule negates the tax-advantaged status of this employee benefit for many closely held corporations.
Disability Insurance
A disability insurance plan provides payments to employees unable to work as a result of a disability. Usually, there is a waiting period before benefits commence, and normally only a percentage (e.g., 60%) of salary is paid. A C-Corporation employer can deduct the cost of a disability insurance plan, and the value of the benefit is not includible in the employee’s income (IRC Sec. 106). However, payments received under the plan are included in the employee’s taxable income [IRC Secs. 104(a)(3) and 105(a); Rev. Rul. 72-191 as modified by Rev. Rul. 81-192], unless the employee paid the premiums with after-tax dollars (Rev. Rul. 75-499). Disability plans are not subject to any nondiscrimination rules under the Internal Revenue Code. Thus, such plans may discriminate as to eligibility, contributions, benefits, and so on without triggering adverse tax consequences to the participants or employer. However, disability plans provided under a cafeteria plan must meet the cafeteria plan nondiscrimination rules, disability plans funded through voluntary employee beneficiary associations (VEBAs) must meet certain VEBA nondiscrimination rules, and disability benefits provided under a pension plan must meet the applicable pension nondiscrimination rules. In addition to IRC nondiscrimination considerations, employers must ensure that no discriminatory acts are committed under other laws. See PPC’s Guide to Compensation and Benefits for coverage of the various nondiscrimination rules.
Educational Assistance Programs
A C-Corporation employer can deduct the cost of an educational assistance program (EAP), and employees can exclude from taxable income up to $5,250 of such benefits per year. To qualify as an EAP (which allows the employee to exclude the income), certain nondiscrimination rules apply to prevent employers from providing this benefit only to owner-employees and highly compensated employees. The biggest stumbling block for closely held corporations in meeting these rules is the requirement that not more than 5% of the amounts paid by the employer be provided for employees who are also more than 5% shareholders in the corporation. This provision negates the tax-advantaged status of this employee benefit for many closely held corporations.
Qualified Transportation Benefits
A C-Corporation employer can provide employees with (a) commuter transportation in a qualified commuter highway vehicle (i.e., a van pool arrangement), (b) transit passes, (c) qualified parking benefits, and (d) qualified bicycle commuting reimbursements. The corporation can deduct the costs of these benefits. Also, if the qualification rules are met, employees can exclude from taxable income a stated amount of the combined monthly value of commuter transportation and transit pass benefits, the monthly value of parking benefits, and the annual value of bicycle commuting benefits. Nondiscrimination rules do not apply to qualified transportation benefits. For 2014, the combined value of commuter transportation and transit passes excludable from income is limited to $130 per month. The amount of qualified parking excludable from income is limited to $250 per month for 2014. The commuter transportation, transit passes, and qualified parking exclusions are all indexed for inflation.
Unlike other qualified transportation benefits that have monthly benefit limitations, the bicycle commuting benefit has an annual limit of $20 times the number of qualified bicycle commuting months during the year [i.e., $240 (12 × $20) annual maximum]. This limitation is not indexed for inflation. A qualified bicycle commuting month is any month the employee (a) regularly uses the bicycle for a substantial portion of the travel between the employee’s home and workplace, and (b) does not receive another qualified transportation benefit (i.e., commuter transportation, transit pass, or parking).
The parking and transit pass benefits normally can be provided in the form of cash reimbursements or by the employer paying the cost directly. However, a cash reimbursement for transit passes is a qualified transportation benefit only if a voucher or similar item that may be exchanged only for a transit pass is not readily available for direct distribution to employees.
For parking that is not on or near the employer’s premises, the income exclusion is available only if the employee commutes to work via mass transit, a qualified commuter highway vehicle, a car pool, other hired transportation, or by any other means.
Cafeteria Plans
Cafeteria plans allow employees to choose among two or more benefits consisting of cash (including cash equivalent benefits) and qualified taxable or nontaxable benefits [such as accident and health insurance, dependent care assistance, flexible spending accounts, etc. (IRC Sec. 125)]. Such a plan permits employees to set aside part of their salary to purchase tax-advantaged fringe benefits. The employee is then able to pay for these benefits with pre-tax rather than after-tax dollars. Unfortunately, cafeteria plans are subject to complex nondiscrimination rules set forth in IRC Sec. 125 and the related regulations. In addition, they may have to file Form 5500 information returns to meet Department of Labor requirements. The biggest stumbling block for closely held corporations in providing a cafeteria plan is the rule that key employees must include in taxable income benefits received under the plan if they receive more than 25% of the nontaxable qualified benefits provided by the plan [IRC Sec. 125(b)(2)]. This negates the tax-advantaged status of cafeteria plans for many closely held corporations.
C-Corporations [other than personal service corporations (PSCs)] generally can select any tax year-end-even if it is different from that of the principal shareholders. This provides tax planning opportunities for the C-Corporation and its shareholders. Most S-Corporations and partnerships (including LLPs and LLCs taxed as partnerships) must make tax deposit payments with the IRS if they want to use a tax year that differs from their required year [IRC Secs. 444, 706(b), 1378, and 7519]. (For guidance on selecting an entity’s tax year, see section 1303.)
C-Corporations can partially deduct dividends received from domestic C-Corporations. If the investor corporation holds 20% or more of the distributing corporation’s stock (in terms of voting power and value), a deduction equal to 80% of the dividends received is available. If the investor corporation holds less than 20% of the distributing corporation’s stock, only 70% of the dividends are deductible. A 100% dividends received deduction applies to certain dividends received from an 80% or more owned corporation that is a member of the same affiliated group as the recipient. Limitations apply with respect to the investor corporation’s taxable income, its holding period in the stock, and the treatment of debt-financed stock.
Shareholders may be able to claim ordinary loss treatment for up to $100,000 of annual losses ($50,000 for single taxpayers) from the sale or worthlessness of C-Corporation shares that qualify as Section 1244 stock. In contrast, losses from partnership interests (including interests in LLCs treated as partnerships for tax purposes) are generally capital in nature.
Many C-Corporations cannot use the cash method for tax purposes. This limits the corporation’s ability to time income and deductions for tax planning reasons and is thus usually considered a disadvantage. In addition, more sophisticated bookkeeping and recordkeeping are necessary to reflect the accrual method.
Relatively small C-Corporations (those that for all prior tax years beginning after 1985 have average annual gross receipts of $5 million or less for each three-tax-year period) can use the cash method assuming they otherwise qualify to do so. For corporations in existence less than three years, the $5 million gross receipts test is performed using the corporation’s shorter period of existence. For prior tax years of less than 12 months, gross receipts are annualized for purposes of meeting the $5 million gross receipts test.
As you can see, there are various reasons to be taxed as a C-Corporation.