Henricks, Martin, Thomas & Zollars, Ltd.
Certified Public Accountants

by Ed Zollars, CPA
Henricks, Martin, Thomas & Zollars, Ltd.

The issue of form of entity is an important one for all of us involved in operating a business. In a recent exchange on CompuServe's Accountants' Forum, I got into a discussion involving the general advantages and disadvantages of C corporation statues. Below I've summarized my response.

This exchange was useful because these individuals had stumbled across advice that may have been second-hand or not completely understood. I find that many people that first venture into this area end up with information that is either blatantly wrong or incorrect for their situation. This couple did sense that there may have been problems with the information they received and began to ask questions. They also indicated they were going to seek out competent local advice on these issues, which is the best method to deal with this whole rather complex issue.

In the original question posed, there was a married couple, each one with their own service business. One was involved in software development and another was involved in business improvement consulting. They had been told that it would be advantageous to be a C corporation due to various tax advantages. Starting below is a summary of my responses to various questions they raised, along with additional comments I've now added.

Claim: Changing these businesses to C corporation status would be advantageous due to the tax advantages offered to those entities.

That may or may not be true and would depend heavily on your circumstances and what you plan to do with the corporation. A number of issues, both tax and nontax, enter into the decision for the type of business entity that should be used.

Generally, C corporations have the advantage of offering better benefits to the owner-employee, including providing medical insurance that is deductible to the corporation and not taxable to the employee-owner. If you don't fall prey to the personal service corporation rules (another issue I'll deal with later), you can also find relatively low tax rates on the first $50,000 of corporate income.

The big tax problem of C corporations is simple--double taxation. That's especially nasty if you trap an appreciating asset inside the corporation (such as goodwill or a software product you may develop) which you later try to sell. A truly nasty double tax occurs if a buyer wants to purchase the assets, which is what most buyers will want to do for a number of reasons.

Also, if you take advantage of the lower tax rates, the double tax comes back to haunt you should you ever try to get those funds out of the corporation. Ultimately, you end up paying personal tax when you try and get those funds out, which is in addition to the tax you originally paid inside the corporation. For that reason, I usually recommend accumulating funds inside the C corporation only when there's a valid business reason to do so.

Even if you decide to leave the funds in the corporation, there's this thing called the accumulated earnings tax that limits the ability for closely held corporations to build up large amounts of funds. Also, the rules involving taxation of capital gains/losses at the C corporation level also make them less than ideal vehicles for holding investment style assets.

What happens in most small C corporations is that the vast majority of income is paid out as salary to the owners each year, with the corporation showing little or no profit. The employee benefits are normally the primary reason for forming one these days, and even then I look at using it principally when there's little chance of an appreciating intangible asset getting trapped inside.

However, there are exceptions to everything here because there are so many variables. For that reason, I'd very strongly suggest consulting with a local tax professional and attorney before taking the steps to incorporate.

Claim: C corporation income is taxed at a flat 25%.

Not correct. The only C corporations taxed at a flat tax rate are personal service corporations, and those are taxed at a much higher rate than 25%. Other corporations are taxed based on a progressive scale, with the federal rate being 15% on the first $50,000 of income. Note that most states also impose a corporate income tax, which may be higher or lower than the individual rates. For instance, Arizona poses a 9% tax on corporate earnings, which is significantly higher than any of the state's individual income tax rates.

Personal service corporations get taxed at the highest corporate rate on all of their earnings. The definition of a PSC is somewhat unclear, especially in the area of "consultants", one of the categories. You need to be very certain whether either you or your wife would fall into this category before even considering a C corporation. Again, this is a job for a local tax professional in possession of all the facts.

Claim: The best plan would be to incorporate, pay employee benefit expenses out of the corporation, take a small salary out of the corporation, and then leave the remainder in to be taxed at corporate rates which would be lower than personal rates.

Well, if you aren't a PSC and if you balance the tax rates, yes this might work as long as you never want to get ahold of the funds personally and also never plan to sell the company or shut it down. The biggest hitch is that those funds are trapped inside the corporation, and any means of getting them out will tend to bring additional taxation.

Before someone mentions it to you, I will tell you that borrowing from your corporation may not be the best idea. First, you may find you fail the "duck test" (if it looks like a duck, quacks like a duck and walks like a duck it's a duck). By that I mean that the IRS may succeed in claiming that wasn't a loan, but rather a dividend (the nastiest word ever spoken around a closely held C corporation). Dividends are fully taxable to the shareholder, and the corporation receives no deduction.

Claim: These individuals are looking for the best way to protect their money and so want to pursue these options.

If you are concerned about legal liability protection in addition to tax planning, I must strongly suggest getting a competent attorney involved in your plans. A botched corporation could leave you with significant tax headaches and inadequate legal protection--you can be in much worse shape than if you've done nothing.

That statement comes from experience--I know of people that have gotten into C corporation status that would now do just about anything to be able to undo the C corporation. The catch is that many are trapped with no good way out of the C corporation status.

Conclusion

The above is a very rough outline of some of the issues that need to be considered in deciding if a C corporation is the proper entity to use in a particular situation. Sitting down with a competent tax advisor and a competent attorney is something that is a requirement to make a proper and informed decision. There simply wasn't enough information made available in the question to determne what form of business either of these individuals should use.

All decisions dealing with form of business involve trade-offs. There is no business vehicle that is perfect for all situations, and none that don't involve certain disadvantages. Making an informed decision requires that you understand both the advantages and disadvantages of the entity you select.

Please call us or send electronic mail if you wish to engage us to consult with you about the form of business in your situation. We are also available for the other services listed on our home page.