Business Entities: C Corporation

A C corporation is a type of business entity. Though the corporation may have many owners, it is nonetheless a single entity in the eyes of the law. Corporations may raise money by selling ownership interests (referred to as stock or shares) to shareholders. If the C corporation earns profits, it usually does one of two things. It distributes the profits to the shareholders in the form of a “dividend” or reinvests the profits in the business. A C corporation is the same corporate entity as an S corporation. However the tax treatment is very different between the two.

When Can It be Used?

A C corporation can be used in almost any case. Though not usually the choice of last resort, it may be useful in those circumstances when, because of some prerequisite, alternative entities could not be chosen.

Strengths

Virtually unlimited in the number and type of shareholders: A C corporation is generally unlimited in the number and type of shareholders it may have—quite unlike an S corporation or even a professional corporation (PC), both of which are somewhat restricted in this regard. Generally, only members of certain eligible professions are allowed to form a professional corporation. S corporations are limited to 100 shareholders who must meet certain eligibility criteria, while a C corporation can have any number of shareholders of nearly any type.

Noncompensation fringe benefits are generally tax free to shareholder-employees: Fringe benefits are generally tax free to the shareholders of a C corporation. Two percent shareholders in an S corporation, by comparison, must pay taxes on the fringe benefits received. By offering numerous fringe benefits to shareholder-employees, the corporation can compensate shareholders in a manner that results in a tax deduction for the corporation and a tax-free distribution to the shareholder.

Owners are generally not personally liable for acts of corporation: The shareholders of a C corporation are generally insulated from personal liability. Liability for corporate action is limited to the extent of the shareholders’ investments in the corporation (what they paid for their shares). This attribute is referred to as limited liability. The limited liability feature may be lost if, for example, the corporation acts in bad faith, fails to observe corporate formalities (e.g., organizational meetings), has its assets drained (e.g., unreasonably high salaries paid to shareholder-employees), is inadequately funded, or has its funds commingled with shareholders’ funds. A corporation’s loss of its limited liability feature is referred to as the piercing of the corporate veil. Buy liability insurance to mitigate your potential loss if the corporate veil is pierced.

Management is centralized: A C corporation offers centralized management through its board of directors. Shareholders of a C corporation indirectly participate in management by electing the board of directors and by voting on certain corporate issues.

Interests can generally be transferred without restriction: Shares of stock of a C corporation can generally be freely bought and sold without consequence to the entity structure (referred to as the free transferability of interests). Contrast this to an S corporation, where, though the shares are also considered freely transferable, a sale of stock to an ineligible shareholder disqualifies the corporation for tax treatment as an S corporation. With a professional corporation, sales of shares are allowed only to members of the same profession.

Flexibility in sharing profits and control: Unlike an S corporation, which can have only one class of stock, the C corporation can issue different classes of stock. In so doing, the C corporation can regulate who can exercise control over the corporation.

Example: If a C corporation needs to raise more money, but it does not wish to give up any more control over the corporation, it could issue stock with no voting rights. However, for potential owners to be interested in buying stock in a company that doesn’t allow them to have a “voice,” the corporation might have to sweeten the deal by, perhaps, giving these investors the right to receive dividends before any other shareholder receives them. The C corporation can do this by issuing a separate class of stock. While an S corporation can issue both voting and nonvoting stock, all outstanding shares of stock of an S corporation must receive an equal right to distribution of dividends and proceeds from asset liquidation.

Life of entity continues indefinitely: A C corporation can “live” forever. This is referred to as continuity of life. It continues after the death, bankruptcy, retirement, insanity, expulsion, or resignation of an owner. Thus, your business will go on even if you don’t.

Tradeoffs

Profits are subject to double taxation: Unlike an S corporation (a flow-through entity), the C corporation is subject to double taxation. The profits are taxable first at the corporate level when earned. They are subject to taxation again at the individual level when and if they are distributed to the shareholders as dividends.

Note: For tax years beginning prior to January 1, 2003, dividends were taxed as ordinary income. In an attempt to mitigate some of the burden of double taxation, various pieces of legislation provide that dividends received by an individual shareholder from domestic corporations and qualified foreign corporations are taxed at the rates that apply to capital gains. Most recently, in general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains, and established new rates for higher-income taxpayers. Capital gains and qualified dividends are now generally taxed at 0% for taxpayers in the 10% and 15% tax brackets; at 15% for taxpayers in the 25% to 35% tax brackets; and at 20% for taxpayers in the 39.6% tax bracket. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.

The effects of the double taxation can be mitigated by paying deductible salaries to shareholder-employees, deductible rent payments to shareholders who rent personal property to the corporation, or deductible interest payments on loans to shareholders. The double tax may even be postponed by retaining profits for other uses (e.g., corporate expansion) rather than distributing them to shareholders. However, if profits are retained in excess of certain limits, the corporation may incur the accumulated earnings tax (AET)—a penalty tax. Generally, the IRS permits the retention of up to $250,000 without penalty. Indeed, a corporation can retain more than this amount if there is a reasonable business purpose for doing so (e.g., diversification or expansion).

Entity may be relatively difficult and expensive to form and maintain: The C corporation may be the most difficult and expensive entity to form and maintain. To begin with, you must file documents with the state (e.g., articles of incorporation), adopt rules for self-government (by-laws), elect corporate managers (board of directors), and hold your first of many organizational meetings.

Entity is heavily regulated: The C corporation is subject to strict regulation by both local and federal governments. For example, the Securities and Exchange Commission, a federal agency, regulates the offer and sale of, among other things, a corporation’s stock. However, federal registration does not apply to private offerings to a limited number of investors, offerings of a limited size, and intrastate offerings. Therefore, such federal securities regulations do not apply to many private small businesses.

Shareholders cannot deduct losses: Unlike those of pass-through entities, shareholders of a C corporation cannot deduct (subtract from taxable income) the corporation’s losses from their personal income. Instead, the losses of the corporation are “trapped” at the entity level and can be taken only by the corporation at some time when it has income. Generally, losses can be deducted by a corporation from income earned in any of the previous 2 years (a “carryback”), or from income earned in any subsequent year up to 20 years (a “carryover”). However, there are several exceptions to the carryback rule.

Shareholders can be taxed on contribution of appreciated property: If a shareholder contributes appreciated property to the corporation, he or she will be taxed unless all of the shareholders’ contributing property control 80 percent or more of the stock after contribution. Contrast this to a partner in a partnership or a member in a limited liability company (LLC), who is generally not taxed on such a contribution regardless of control. However, there may be later consequences for a partner or an LLC member who contributes appreciated property, including possible recognition of gain.

Liquidation of the corporation is a taxable event: When the corporation is liquidated (distributes all of its assets to shareholders), it is treated (and taxed) as if it sold the assets to the shareholders at fair market value (FMV). As a result, both the corporate entity and the individual shareholders may face tax consequences. A partnership or LLC, on the other hand, can generally liquidate with one level of taxation. However, a partner or LLC member may recognize gain or loss to the extent money is distributed to the partner or member in liquidation of the partnership or LLC.

Setting Up a C Corporation*

Consult an attorney: You should consult an attorney experienced in business planning. The attorney should know the laws in your state (or your state of incorporation) that prescribe the requirements you’ll need to fulfill.

Deliver articles of incorporation to secretary of state: Generally, to create a C corporation, you must file articles of incorporation with your state. State law will dictate what you will need to include in this document. You must also adopt by-laws, elect a board of directors, and hold your first organizational meeting.

Your corporation is automatically a C corporation: The decision to be a C corporation is one of default. In other words, your corporation is automatically a C corporation unless approval is granted from the IRS for taxation under a different provision, such as an S corporation election.

*Checklist is not exhaustive

Tax Considerations

Profits of the C corporation are taxed twice: The profits of a C corporation are subject to double taxation: once when earned by the corporation, and again when distributed to the shareholders in the form of a dividend.

Example: As an oversimplified example, assume that shareholder A is in the 35 percent individual tax bracket and is the sole shareholder of XYZ corporation. XYZ is a C corporation in the 34 percent corporate tax bracket. As a C corporation (not a pass-through entity) with $100,000 in profits and assuming no deductions, XYZ’s corporate tax would be $34,000 (34 percent of $100,000). The remaining $66,000, if distributed to shareholder A as a dividend, will be taxed again at 15 percent: 0.15 x $66,000 = $9,900 in taxes. When combined, the tax rate for the corporation and the shareholder would equal 43.9 percent for a total of $43,900 in taxes.

If instead XYZ were an S corporation (a pass-through entity), only the shareholder would be taxed. Shareholder A would pay $35,000 (35 percent of $100,000) in income tax. Total taxes paid on the $100,000 would be $8,900 less than it would be in the scenario above.

By paying salaries or providing fringe benefits to shareholder-employees, or by paying rent or lending money to shareholders, you can mitigate the effects of double taxation. The double taxation may even be postponed by retaining profits for future corporate uses.

However, if profits are retained in excess of certain limits, the corporation may incur the accumulated earnings tax (AET)—a penalty tax. Generally, the IRS permits the retention of up to $250,000 without penalty. Indeed, a corporation can retain more than this amount if there is a reasonable business purpose for doing so (e.g., diversification or expansion).

Dividends: taxable to shareholder, nondeductible by corporation: When the corporation distributes profits to shareholders in the form of dividends, the shareholders are taxed on the distribution. In addition, these payments may not be deducted by the corporation (unlike fringe benefits and interest, rent, or wage payments). The double tax may be avoided if the corporation, instead of issuing dividends, distributes income to shareholders in the form of salary, fringe benefits for services rendered, payments of rent, or interest on loans to shareholders. However, if these alternate forms of compensation are deemed unreasonable, the IRS may classify them as dividends “in disguise” and tax them as such.

Fringe benefits are tax free to shareholder-employees, deductible by corporation: Fringe benefits (e.g., health insurance, tuition reimbursement) are generally tax free to the shareholder-employees of a C corporation. In addition, the C corporation can deduct from its taxable income the fringe benefits provided. Two percent shareholders in an S corporation, however, are taxed on the fringe benefits received. The corporation may avoid some of the double taxation if it provides numerous fringe benefits to shareholder-employees. Fringe benefits are deducted from income. This leaves less (taxable) profit for distribution to shareholders.

Wages are taxable to shareholder-employees, deductible by corporation: A shareholder may be employed by the corporation, in which case the shareholder-employee is taxed on his or her compensation (wages). The corporation can deduct the wages paid to the shareholder. Similar to fringe benefits, wages are not subject to double taxation. Moreover, if the corporation is taxed at a higher rate than the shareholder-employee, then he or she may save in taxes. If the wages paid to a shareholder-employee are unreasonably high, the IRS will likely recharacterize the wages as dividends and disallow the corporation from taking a deduction for wages paid.

Rent is taxable to shareholder, deductible to corporation: A shareholder can rent personally owned property to the corporation. The corporation can deduct the rental expense and the shareholder is taxed on the rent received. If rent payments are considered unreasonably high, the IRS may classify them as dividends and tax them as such.

Shareholder loans to corporation—interest payments deductible by corporation: Shareholders can loan money to the corporation. The primary advantage of the issuance of debt is the avoidance of the double taxation. The corporation deducts from its taxable income the interest payments made on the loan (something it can’t do with dividends). The shareholder, however, pays tax on the interest payments received but will get the loan principal back without tax ramifications. The loan must be well documented or it will be classified as a dividend in disguise and taxed as such.

Losses cannot be deducted by shareholders: Losses of a C corporation, unlike the losses of an S corporation, are not deductible by shareholders on their personal tax return. Generally, losses can be deducted by a C corporation from income earned in any of the previous 2 years (a “carryback”), or from income earned in any subsequent year up to 20 years (a “carryover”). There are several exceptions to the carryback rule.

Penalty taxes—alternative minimum tax (AMT) and accumulated earnings tax (AET): The AMT is assessed when a corporation—through the use of exemptions, deductions, and credits—pays little or nothing in taxes. The AMT ensures that corporations with income will pay some tax. The AET, conversely, is imposed when a C corporation, rather than distributing profits to shareholders as dividends, retains them in excess of certain limits. The IRS generally permits retention of up to $250,000—more if for a valid business purpose (e.g., expansion or diversification). Both the AMT and AET are typically not imposed upon S corporations. To avoid the AET, the corporation’s board of directors must discuss (in meetings) and document (in minutes) the need to retain profits. Also, the corporation should set up an appropriate retained earnings account, so that the corporation has a method by which shareholders are regularly informed as to how much of its earnings will be retained.

If you have questions, contact the experts at Henssler Financial: