Should You Form a C Corporation?

Although most of our businesses are proprietorships, partnerships, limited liability companies (LLC), or S Corporations, some printers elect to form C Corporations because they think they can save cash in taxes. However, unless there’s a special situation, you won’t. You pay more because C Corporations are taxed once at the corporate level and then again as salary or dividends are paid out.

Granted, there is a timing difference, but the overall dollars paid will be more in a C because of the two tax layers. An S Corporation, on the other hand, passes the taxable income or loss directly through to the owner and avoids double taxation, as other business forms do.

You could leave earnings in the C Corporation and avoid personal taxes, but realize that in businesses like ours we always take the money out. It might not be until we’re 80 or when we croak, but we take the money out sooner or later. On the other hand, ExxonMobil and other large, publically traded C Corporations never take all of the money out.

Please Note: The following sounds a lot like tax advice—it is not. It is general information on the topic, offered so you can discuss the tax issues with you professional advisor.

Specifics & Details

In a C Corporation, the first $50,000 of net income is taxed at 15 percent, the next $25,000 at 25 percent, the next $25,000 at 34 percent, and the rates go up from there. Then wages or dividends paid to the owners are taxed again at the personal rate—10 percent (very low income) to 35 percent (2011 rates). In an S Corporation, earnings are taxed only at the personal rate, so the C Corporation owner will pay higher taxes sooner or later because of the combined rates.

So why wouldn’t everyone want to be an S Corporation? Well, it is not always available. New Hampshire and Washington, DC, don’t allow S Corporations, for instance. Another reason not to be an S Corporation might be state taxes. The way states tax an S Corporation varies from favorable to unfavorable, so state taxes are a key deciding factor.

My point is, if your company is a C Corporation there should be a specific reason why it is. Here are few:

Start-Up: A C Corporation could be right for start-ups that expect losses in the early years. In a C Corporation these losses can be carried forward to offset later years’ income. An S Corporation would see the losses pass to the owner, who could only use them that year to offset other income. It is also reasoned that once earnings begin the corporation can change to an S Corporation. The problem I find here is that most never review their status.

Growth: Many growing companies don’t take money out of the business. Instead, they pay taxes at the lower rate and then reinvest to expand. So the theory goes: remain a C Corporation, pay the one lower corporate income tax, and then reinvest the earnings. The problem here is that, sooner or later, we take the money out. When we do, it triggers much higher taxes than if we had been an S Corporation all along. So being a C Corporation during the growth years and then switching to an S Corporation in later years could make sense if people really do it.

Transitioning: A C Corporation could be a device for a business transition. If mom and pop own 99 shares and junior owns one, then the stock of mom and pop could be repurchased by the corporation, over time reducing it to zero shares for mom and pop and one share for junior—leaving junior with 100 percent of the corporation. However, this is tricky, if still allowed. Don’t do it without proper legal and tax advice.

Avoid the Rent Trap

When C Corporations occupy a building owned by the owner of the corporation, it’s easy to increase or decrease the rent from year to year to avoid having corporate income and thus avoid paying any corporate income tax. The problem with this is that it is a big-time audit trigger and could result in serious issues with the IRS. Besides, if you have to mess with rent to avoid income, why not be an S Corporation in the first place? After all, the rent in this scenario goes to the owner as well creating taxable income.