Small business corporations are either C or S corporations — these designations refer to the subchapters of the tax code that governs them. C corporations are governed by 26 USC Chapter 1, Subchapter C - Corporate Distributions and Adjustments.
Although C corporations are the most expensive entity to start, operate, and maintain, they do have many advantages. A C corporation can offer many fringe benefits that are taxed less than they would be under sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations. Many C corporation benefits, such as health insurance, are not subject to either ordinary income taxes or employment taxes, while fringe benefits offered by other business entities are always subject to employment taxes. Income can be split between the owners and the corporation to reduce overall taxes. Additionally, funding for the corporation can be increased by selling shares of stock.
However, the tax advantages must be weighed against a greater complexity of operations, complex tax rules, and legal and accounting costs. Corporation franchise taxes, and the professional help, especially in the form of legal and accounting services, needed to set up and operate the C corporation increases the cost of doing business.
Incorporated businesses are 1st incorporated as a C corporation. If the shareholders wish to be taxed like a partnership, then they would elect the S corporation status. If the business will earn profits right from the beginning, then the C corporation would offer more tax saving opportunities and greater funding sources for future growth. However, if a business is expecting to incur losses in the beginning, as is often the case, then many businesses choose to start out as an S corporation so that the losses pass-through to the owners, allowing them to deduct losses against other income. When the corporation becomes profitable, then the business owners can convert it to a C corporation.
Setting Up a C Corporation
The states provide the rules for incorporation, not the federal government. Some states, such as Delaware, Nevada, and Wyoming assess very low or no taxes on corporations within their states. Although a business can choose a state of incorporation other than where they are doing business, states also have requirements for any foreign corporations, which are corporations doing business within their borders that were incorporated in another state, including filing tax returns, to pay franchise taxes and other corporate taxes. (More: Multistate-Business Taxation) However, there may be nontaxable benefits to being a foreign corporation that the business owners would want to take advantage of, such as better protection from liability or not having to disclose the names of corporate shareholders. Setting up a corporation requires an application to the Secretary of State that includes the corporate name, the articles of incorporation, the address and purpose of the corporation, and the name of the person who is in charge of receiving legal papers in case the corporation is sued. Filing fees generally range from $50-$1000.
If the right procedures are followed, then the business receives a corporate charter, which gives it the right to operate as a corporation within the state. Afterwards, the corporation must hold the 1st meeting of shareholders, appoint officers and directors, and write bylaws that govern the corporation's operation. To maintain legal status as a corporation, it must keep corporate records and hold an annual meeting of shareholders and directors. However, if the corporation has few shareholders, many states eliminate many of these requirements.
The following discussion covers closely held C corporations with few shareholders, since the taxation of such corporations is simpler.
Taxation of C Corporations
A corporation is treated as a legal person under law; thus, it can own property, enter into contracts, and sue or be sued. The corporation is distinct from the shareholders, and the liability of the shareholders is limited to their investment in the corporation. Their personal assets are not at risk, except in certain specialized cases where the shareholders form a corporation to commit fraud, in which case, state law allows a "piercing of the corporate veil" to hold the shareholders accountable.
A corporation can have 1 or more stockholders. When the corporation has just 1 stockholder, that person must serve as the director and president, as well as secretary and treasurer. Shareholders who work in the corporation, as is often the case in closely held corporations, are treated as employees of the corporation under tax law — they are not self-employed.
A C corporation, or a partnership where at least 1 partner is a C corporation, must use the accrual method of accounting if its average annual gross receipts exceed $25 million for the 3 tax years preceding the current tax year (IRC §448). This requirement does not apply to farming businesses. If the corporation has not been in existence for 3 years, then the average must be computed for the time that it has been in existence. If the applicable time period is less than 12 months, then the income is annualized.
C corporations are subject to a flat tax rate of 21%.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, corporations have received the best benefits, which includes the following changes:
- The top corporate tax rate is reduced from 35% to a flat rate of 21%.
- Business interest is no longer fully deductible. Instead, excluding depreciation, the deduction cannot exceed 30% of income.
- Eliminates the corporate alternative minimum tax and an AMT carryover credit can be used to offset regular income tax liability for any tax year, and can even be refunded.
- New investment purchases can be fully expensed in the 1st 5 years, but then it is phased out over 5 more years.
- The §179 deduction is increased to $1 million, adjusted annually for inflation.
- The deduction of net operating losses is limited to 80% of taxable income.
- The §448 gross receipts test has been increased from $5 million to $25 million, allowing businesses with average annual receipts less than $25 million in the 3 previous years to use the cash method of accounting. Furthermore, the business can use the cash method of accounting even if it failed gross receipts test in 1 or 2 years during the 3-year lookback period.
- Previously, research and development expenses could be immediately deducted, but now they would need to be written off gradually.
The new law also changes the taxation of C corporationS from a worldwide system, where all income earned by a corporation was taxed, regardless of where the income was earned, to one more like a territorial tax system, where income is taxed by the country in which it is earned. This is accomplished by providing a 100% deduction on dividends received by a US corporation from a foreign subsidiary, which includes any company that the C corporation owns at least 10% of the foreign corporation. However, the stock on which the dividend was received must have been held at least 366 days during a 731-day period, beginning 365 days before the dividend date.
Unlike the changes for regular taxpayers, most of which expire in 2025, most of the tax changes for businesses have been made permanent.
Also, this new tax law lowers the tax rate on repatriated funds held overseas by corporations. Previously, corporations were taxed at the maximum rate of 35% on their worldwide income, including income earned in other countries, but this tax can be deferred on international earnings by keeping the funds overseas, which many corporations have done. To promote repatriation, a special tax rate will be applied to repatriated funds: 15.5% rate for funds held as cash and 8% for non-cash holdings.
Excess Employee Remuneration Not Deductible
For publicly traded corporations, this new law also eliminates the deduction for any compensation exceeding $1 million for a covered employee, which includes the principal executive officer, financial officer, and 3 of the other highest-paid officers. Although this is like previous law, the new law now extends the deductible limit for performance-based compensation.
Previous to 2018, a disadvantage to C corporations is that they do not benefit from the favorable long-term capital gains tax rate, but now that the corporate tax rate has been reduced to a flat 21%, this disadvantage is virtually eliminated. All capital gains, whether long-term or short-term, are subject to the corporation's tax rate. Another disadvantage is that capital losses can only be deducted from capital gains, not from other income. Capital losses that exceed capital gains must 1st be carried back 3 years to offset any capital gains during those years, then carried forward for 5 years. There is no option to use only the carryforward period. If the capital losses are not offset by capital gains within that time, then the remaining losses can never be deducted. The corporation can claim any refund for the carryback period by filing Form 1120X, Amended U.S. Corporation Income Tax Return. Because the tax code has specific rules for capital losses, they cannot be combined with other income to increase net operating losses nor to reduce other income. Capital losses cannot even be combined with other capital losses from other years. Furthermore, the losses used to offset capital gains must progress sequentially from the earliest carryback period, then forward. In other words, if a corporation has capital losses that are carried back for each of the 3 previous years, then capital gains must 1st be offset by the losses from the 3rd previous year, then the 2nd previous year, then the previous year. Whatever remains can be carried forward.
C corporations are subject to double taxation because the dividends they pay out are taxable to the shareholders but they are not deductible by the corporation. Shareholders who are also employees may avoid this undesirable result by paying out all profits in the form of salary, bonuses and fringe benefits. Sometimes, it may be better to leave some of the money in the corporation as retained earnings, especially if the corporate tax is less than the shareholder's marginal tax rate. Moreover, if the business requires a lot of money for growth, then the C corporation can retain its earnings to invest in its own growth, which lowers the overall tax bill.
For instance, the tax rate on corporate income is only 21%. If this amount were paid out as wages, then it would not only be subject to the taxpayer's marginal tax rate, which will probably be higher, but it will also be subject to employment taxes, equal to 15.3% of the whole amount up to the Social Security wage limit; any amounts over the limit will still be subject to the 2.9% Medicare tax. Hence, major tax savings can be achieved by splitting income between the corporation and the employee-owners.
A major disadvantage to C corporations that suffer losses, unlike the losses of an S corporation, is that the losses do not pass through to the shareholders. Losses can only be deducted against corporate income, although they can be carried back or forward to offset income in those tax years.
C corporations must file Form 1120, U.S. Corporation Income Tax Return, due on the 15th day of the 3rd month after the end of the corporation's tax year, which, for a calendar year, is March 15. A corporation can also get a 6-month extension by filing Form 7004, Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns. Corporate tax forms must also be filed for the state in which the corporation does business, which may differ from the federal rules. All states charge an annual corporate franchise tax which typically ranges from $50-$800. The corporation must also make estimated tax payments, just as self-employed individuals do.
There can be savings in taxes if there is income splitting between the corporation and the shareholders. Although many of the major fringe benefits are not subject to either income or employment taxes, fringe benefits must be made available to all full-time employees, not just to the owners or the corporate officers.
Another tax advantage of the C corporation is the dividends received deduction that allows the corporation to receive dividends from another corporation, where 70% or more of the dividend income is tax-free. The corporation could deduct 80% of the dividend, if it owns at least 20% of the stock of the other corporation, and it could deduct 100% of the dividend if the corporation was part of the same affiliated group. However, the Tax Cuts and Jobs Act lowered the 70% deduction and the 80% deduction to 50% and 65% respectively. The 100% deduction provision is unchanged.
C corporations may be subject to other types of taxes that do not commonly apply to small business corporations. The personal holding company tax applies if 60% or more of the corporation's income comes from investments, such as royalties and dividends, and the number of shareholders does not exceed 5. The accumulated earnings tax is a 20% surcharge when accumulated earnings exceeds $250,000 (IRC §535).
Starting in 2017, the Surface Transportation and Veterans Healthcare Choice Improvement Act of 2015 is modified some business filing dates:
- partnership returns must be filed by March 15, whereas previously they were due by April 15;
- returns for C corporations are due by April 15, whereas previously, corporate filed tax returns were due by March 15;
- employers are now required to file W-2 forms and 1099 forms with the IRS by January 31, whereas previously, the returns were due to the IRS by the end of February. In any case, these forms still must be mailed to employees and independent contractors by January 31.
Funding the Corporation
To capitalize the corporation, the owners can deposit money in a corporate bank account or transfer property to the corporation in return for shares, which is tax-free if tax rules are followed. A corporation cannot be initially funded by loans from the shareholders — they must make an equity investment in their new venture.
Most states require that the corporation have adequate capitalization to begin business so that expenses and debts have a higher probability of being paid; otherwise, the owners can be held liable for the corporation's undercapitalization, a common reason that the corporate veil is pierced.
Section 351 Transfers
Property can be transferred to the new corporation without any tax consequences until the shareholder sells the stock received in return for the property, and only if the stock price is higher than the shareholder's tax basis in the stock. The stock acquires a substituted basis of the property transferred for the stock. When the shareholder sells the stock, then the taxable profit equals the stock sale proceeds minus the tax basis of the stock, which is equal to the tax basis of the property transferred.
Example: You have an office building in which your adjusted basis is $50,000 and you transferred it to your new corporation in exchange for 1000 shares. Later, you sell your shares for $120,000. Your capital gain will be $70,000.
There are 4 conditions that must be satisfied for a transfer to qualify under IRC §351:
- The corporation must receive real estate or personal property in exchange for the stock.
- The shareholders must receive only stock for the property, not cash, bonds, corporate promissory notes, or even stock warrants or stock options. The value of the stock must equal the fair market value of the property transferred. If the shareholder receives anything other than stock, then it is treated as taxable income to the shareholder.
- The shareholders must collectively own at least 80% of the new corporation after the transfer.
- There can be no exchange of stock for services; otherwise the shareholder will owe income tax on the value of the stock.
Under §351, shareholders cannot claim losses when transferring property, especially shareholders with more than a 50% interest in the corporation since they are subject to related party rules. Each §351 transfer should be recorded in the corporate minutes and listed on the tax returns of each shareholder on the 1st corporate tax return. Shareholders need to keep these records for at least 3 years after they dispose of the shares. Section 351 applies only to federal tax law, not to state or local tax laws, so property transfers may be taxable under state or local law, or there may be a reassessment on the property transferred, especially for real estate.
Getting Money Out of the C Corporation
When shareholders sell their stock, capital gains must be paid on any gains. If the stock was held for longer than 1 year, then it is taxed at the reduced long-term capital gains tax, which currently is 0%, 15%, or 20%, depending on income; otherwise, the gain is taxed as ordinary income. Unless the stock qualifies under §1244, capital losses can only be used to offset up to $3000 of other income. However, capital losses can be used to offset any amount of capital gains from other sources that the shareholder receives. If the corporate stock qualifies as small business stock under IRC §1202 and §1244, there may be additional tax advantages. See Small Business Stock Sales And Exchanges for more information.
Shareholders have several options to profit from their C corporation besides selling their shares or receiving dividends. Shareholders of closely held corporations can be paid as employees for the corporation, which is often the case. However, there are tax penalties against excessive salaries, since employee-shareholders attempt to prevent double taxation by paying out all the corporation's income as wages, bonuses, and fringe benefits. Although dividends are subject to corporate tax and the shareholder's marginal tax rate, this disadvantage of double taxation is offset by the fact that dividends are not subject to employment taxes.
Shareholders can also take out loans from the corporation, but the loans must be based on a bona fide agreement, such as a legal promissory note, where the shareholder promises to pay a stated amount of interest for the loan. However, loans for less than $10,000 can be interest-free, without tax consequences. Corporate records should record all shareholder loans; there should be a promissory note for the loan with an interest rate that is at least equal to the applicable federal rate; the note must be legally transferable to a third-party and secured by collateral; and the corporation should have the right to sue or take the collateral if the loan is not repaid.
A shareholder can also lease property to the corporation, which can be advantageous because the lease income is not subject to employment taxes and may even incur a loss which can be deducted against the shareholder's other income. However, the income will be subject to passive loss rules. Another advantage to leasing property to the corporation is that it will not be subject to the claims of creditors of the corporation. Commonly, shareholders lease real estate to their corporations, but other property can also be leased, such as electronic equipment.
Tax Tip: Do Not Use a C Corporation to Hold Investments
Many investors use some type of business entity to hold their investments — mainly to limit their liability. The most common entity is the limited liability company, since it offers limited liability and tax advantages, and LLCs are easier to set up than C corporations. Here is a summary of the reasons why C corporations should not be used to hold investments:
- The marginal tax rate may be higher than individual tax brackets at lower income levels, and the corporation has no 0% bracket
- a personal holding company tax is assessed on income if the corporation has 5 or fewer shareholders and at least 60% of its income comes from investments
- a corporation has no favorable long-term capital gains rate, although this has largely been mitigated by the 21% flat rate.
- capital losses can only be deducted from capital gains, and the losses must be carried back 3 years 1st, then carried forward 5 years
- since there is no option to only carry forward the losses, an amended corporate tax return must be filed to offset the carryback losses
- if the losses are not used up within the 9-year period, then they are lost forever.
Losses are Limited in Transactions Between Related Parties
No losses can be claimed on sales to related parties, such as selling a corporate computer or a business interest to your spouse. Instead, the amount that would have been claimed as a loss to an unrelated party is added to the basis of the property, so that if the related transferee later sells the property to an unrelated party, then gain or loss is calculated from the increased basis. So if the corporation has a basis of $3000 in a computer, which is sold to a related party for $1000, then the corporation cannot deduct the $2000 difference between its basis and the sale price. However, if the related party sells that computer for $1200 to an unrelated party, then, if the computer was used in a business, then $1800 can be claimed as a loss, equal to the $3000 basis minus the $1200 sale price.
Related parties include both blood relatives and other businesses that the taxpayer has an ownership interest. Blood relatives include lineal ascendants and descendants, such as parents, grandparents, children, grandchildren. However, cousins and in-laws are not considered related parties.
The tax code defines businesses as related parties:
- corporations that are members of the same controlled group
- a C corporation and an S corporation or 2 S corporations if the same taxpayer owns at least 50% of the value of the outstanding stock in each company.
Related parties also include partnerships and their partners, and limited liability companies and their members.
Additionally, the tax code provides for constructive ownership rules to prevent abuses, so that if the taxpayer exerts significant control over the business through a significant ownership by related parties, then the percentage of ownership is determined by the aggregate shares held by the related parties. So if a taxpayer owns 30% of the shares of a corporation and his spouse owns 25% of the shares, then the taxpayer will be considered to constructively own more than 50% of the corporation.
C Corporation Dissolution
C corporations can be dissolved with the assent of more than 50% of shareholders. However, a corporation can also be dissolved by operation of law, especially if the corporation does not pay state taxes or fees. When a C corporation dissolves, its assets are distributed to the shareholders in proportion to their ownership interest. If the value of the transferred assets exceeds the shareholders tax basis in the stock, then a capital gain will be recognized, equal to the value of the property received minus the tax basis of the stock. If the corporation claimed depreciation on its assets, which is often the case, then there may also be a recapture of the depreciation deduction if the fair market value of the property exceeds its depreciated basis.
One possible way to reduce taxes is to convert the C corporation to an S corporation before liquidating, so that the shareholders can claim the losses on their individual tax returns. The dissolution of the corporation must be reported to both federal and state tax authorities. The IRS should be notified by filing Form 966, Corporate Dissolution or Liquidation. (IRC §331-338)
Tax Tip: Incorporate in Nevada rather than Delaware, but Either State is Better than Other States
Most of the laws that govern corporations are state laws, and many of the laws that pertain to how the corporation operates depends, not necessarily in the state in which it operates, but in the state in which it is incorporated. Because a corporation's operations may cover many states, there usually is no legal requirement to incorporate in a particular state, so owners of business entities have a choice in which state to incorporate. Many choose the state in which they live, but there are definite advantages to incorporating a small business in either Nevada or Delaware. Note, however, that lower costs or lower taxes are not advantages. Both states have various fees for forming a corporation. A major disadvantage with Delaware is that it has an 8.7% corporate income tax, whereas Nevada has no corporate income tax. However, regardless of the state of incorporation, all corporations must register in states in which it does significant business. If a corporation is not chartered in the same state in which it does business, then it must register as a foreign corporation. Foreign corporations must file tax returns and pay taxes in all states in which they do significant business or have significant assets, depending on state law. Hence, there is no tax savings if the business is not also in Nevada. If you earned most or all your income within a particular state, then you must file a tax return for that state and pay the taxes that are assessed on foreign corporations for that state. Although you may decide not to notify your state that you are operating as a foreign corporation, remember, the IRS generally shares its data with state tax authorities.
The main advantage for incorporating in Nevada rather than other states, including Delaware, is greater corporate privacy and protection from liability. Nevada does not require disclosure of the corporation's principal business or even main offices or locations outside of the state. Furthermore, shareholders' names are not part of the public record.
Generally, the officers and directors of a corporation must be listed in the articles of incorporation and in annual reports. Nevada — and Wyoming — allow the use of nominees for the directors and officers of the corporation instead of the owners. The nominees have no authority to run the corporation nor do they have any signature authority for bank accounts or for entering contracts. Their only purpose is to protect the privacy of the owners. This may be useful, for instance, if one of the owners may be subject to a lawsuit. Valuable assets, such as real estate, can be owned by the corporation, and since the owner is not listed in any public documents of the corporation, lawyers will have greater difficulty finding significant assets of the potential defendant by searching the public record.
Another advantage for small corporations incorporating in Nevada over other states, including Delaware, is that directors, officers, and shareholders of the corporation have greater protection from liability, primarily by making it much more difficult to pierce the corporate veil and by disallowing joint and several liability.
Generally, shareholders of a corporation are not liable for the debts or judgments of the corporation, which is one of the main advantages of incorporating a business. However, most states have laws that allow the owners of the corporation to be held liable for the corporation's debt or judgments, thus piercing the corporate veil. There is wide variation in the laws that allow the piercing of the corporate veil. Many states require adherence to formalities that serve no real purpose for a corporation owned by a single shareholder. However, if these formalities are not adhered to, then the corporate veil can be pierced, especially in these states: California, Florida, Georgia, Louisiana, New York, Pennsylvania, and Texas. Nevada laws make it the most difficult state in which to pierce the corporate veil.
Nevada also does not allow joint and several liability, which is the ability to collect an entire debt or judgment from anyone of those found liable. In Nevada, the courts must apportion responsibility among the defendants and any judgments against any of the defendants cannot exceed their apportioned share of responsibility.
Corporations are subjected to a graduated income tax, just like individuals, but the rates are different. Note, however, that the tax rates jump around as income increases. For instance, the top tax rate of 39% only applies to the amount over $100,000 but less than $335,000 (this is the tax law's answer to spaghetti code). Note also that for incomes greater than $18,333,333, the tax rate is a flat rate of 35% on the entire amount:
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