C Corps Remain a Bad Idea for Most Business Owners
Posted August 2, 2018
The hot question since the passage of the Tax Cuts & Jobs Act of 2017 and Section 199A is, “Should I revoke S Corp status and go to C Corp?” The answer is No. What is interesting is that Wharton School at University of Pennsylvania in a June article estimated that approximately 235,000 business owners will convert from a pass-thru entity to a C corporation in 2018. Yuck!
The primary motivation is the seemingly attractive 21% tax rate for C corporations and while this might be lower than some taxpayer’s marginal rate, this is a sucker hole for business owners for two painfully obvious reasons. First, your marginal rate might be 24% or 33%, but your effective tax rate (or blended tax rate) is much lower. We’ll show you… not to worry.
Second, there is a little thing called double taxation where the C corporation pays a tax and then the shareholders pay a dividend tax on the money that is distributed. And… if you think you’re a smarty pants and say, “Yeah, but, I’ll just keep all my money in the C corporation for a rainy day and lower tax rates,” there is another little thing called accumulated earnings tax.
Let’s illustrate this with some good old fashioned devils buried deep into the details. Assumptions include-
- Section 199A deduction for the S corporation’s shareholder
- $24,000 in standard deduction
- 3.8% surtax on top of the 15% capital gains tax rate for the $300,000 column
Buckle up buttercup ’cause here we go-
|S Corp Income||100,000||200,000||300,000|
|Total S Corp Tax Pain||13,100||36,390||62,626|
|C Corp Income||100,000||200,000||300,000|
|C Corp Tax||21,000||42,000||63,000|
|Total C Corp Tax Pain||21,000||65,700||107,556|
|Effective S Tax Rate||13.1%||18.2%||20.9%|
|Effective C Tax Rate||21.0%||32.9%||35.9%|
|Delta (extra tax because of C Corp)||7.9%||14.7%||15.0%|
As you can see, a C Corp does not make sense after you add in capital gains tax on the dividends. This in turn makes sense- the lawmakers didn’t set out to kill S corporations. They set out to give every business owner a tax break. Geez… half of Congress (535 doesn’t divide evenly, we get it) probably run S corporations on the side for their consulting and speaking gigs.
Also note the effective tax rate (or labeled as tax “pain”) for the S corporation owner. At $100,000 in net business income, the total tax pain including payroll taxes is 13.1%, and at $200,000 it is only 18.2%. This is still well below the C corporation tax rate of 21%.
One more thing that is not computed above; C corporations do not get the Section 199A deduction which is 20%. 20% times the marginal tax bracket of 15% is another 3% savings; 20% times the marginal tax bracket of 37% is another 7% savings. So, please pump the brakes on the “I wanna dump my S Corp for the magical tax arbitrage offered by a C Corp” nonsense. Wow, that was harsh. We did tell you to buckle up but then we offended you by calling you buttercup. Safety with an insult.
If you think you are clever and attempt to accumulate your C corporation’s earnings and not pay out dividends, you could trigger the accumulate earnings tax (AET). This tax is specifically aimed to prevent tax avoidance by not paying out dividends.
Businesses can accumulate earnings, no biggie, just ask Apple. But Apple has to justify why it is holding back so much of its earnings… and they do that by saying, “Well, we need it for this and we’re accustomed to that, and we have this thing coming up, baby needs new shoes, and blah blah blah.” Here is a list the IRS utilizes in addition to shoes-
- Providing for bona fide business expansion or plant replacement.
- Acquiring a business enterprise through purchasing stock or assets.
- Facilitating the retirement of company debt created in connection with its trade or business.
- Providing necessary working capital for the business.
- Providing for investments in or loans to customers or suppliers if necessary to maintain the business of the corporation.
- Providing for contingencies such as the payment of reasonably anticipated product liability losses, actual or potential lawsuit, loss of a major customer, or self-insurance.
But if you don’t have a good argument, then IRS could whack you with the AET. Here is a quick list of activities that do not bode well for accumulating earnings in your C corporation-
- Loans to shareholders or related parties.
- Payments by the corporation that personally benefit the shareholders.
- Investments in assets having no reasonable relationship to the corporation’s business.
- A weak dividend history.
- Retention of earnings to provide against unrealistic hazards.
- Working capital levels that appear high in relation to need.
- Salaries paid to shareholder/employees that are either extremely high (avoiding corporate tax) or extremely low (avoiding shareholder tax).
We bet that before you read this list, you already had some of these ideas incubating in your brain. Again, you’re not the first wizard to run a business. The funny thing about this list is that there was a wizard or two, way back when, who did this… and got caught… and ruined it for all of us. Remember that pigs get fed, hogs get slaughtered.
The accumulated earnings tax is 20%, which shockingly matches the highest dividend tax rate for individuals.
Spending Your Money
Who wants to keep all their money in their business? Don’t you want to spend your money? If you say to yourself that you’ll keep your taxes lower by not paying out dividends and you also say to yourself that you can avoid the accumulated earnings tax because you have a good excuse for your piles of money, you are now tying up your money and you can’t spend it.
So if you listen to some people talk about keeping money in the C corporation to enjoy the 21% corporate tax rate… and paying out dividends at a later date when you might have a lower capital gains and dividends tax rate, your money is not your money. In other words, why the heck do you want to work your butt off and not be able to enjoy the fruits of your labor?
Lastly, your objective in life is to build wealth… and if you can save some taxes along the way, then great. But don’t stunt your wealth building for the sake of saving some taxes. By needing to leverage your money into wealth building and to save overall taxes, the C corporation is a bad idea.
Jason Watson is the Managing Partner of the Watson CPA Group, a business consultation and tax preparation firm, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online.