What is the State of the C Corporation as We Approach Mid-2020
Our goal in this article is to provide an overview of the tax issues impacting whether your clients should incorporate the business or not.
Given all that has gone on in our professional and personal lives, it may be difficult to focus on anything outside of our health and keeping business running. For tax and accounting professionals, part of that business is ensuring clients are advised on not only the function, but the form of their livelihoods. To that end, tax expert Michael Pusey, CPA takes a closer look at the current state of the C corporation and whether or not it makes sense for your business clients.
The Big Picture
The C corporation is, tax wise, most famous for its status as an entity apart from its owners. The income is not only taxed under separate corporate rates but the distribution of its income is normally taxed a second time as a dividend.
In general, distributions to shareholders are taxable as dividends to the extent of accumulated earnings and profits, or current E&P. Among the adjustments in such analysis is the corporate income tax itself, which reduces E&P but not corporate taxable income.
Distributions to shareholder may well be deductible expenses at the corporate level, notably reasonable rents for shareholder-owned assets and reasonable salaries for shareholder services. The issue of whether owner compensation in a C corporation context is “reasonable” may well lead to taxpayer-IRS disputes. This often emphasizes the importance of time logs, a history of accomplishments, etc., which is often not an issue in other contexts.
The C corporation operates generally under the same manifold nuances of what constitutes income (Section 61) and what qualified as “ordinary and necessary” business expenses under Section 162.The reasonableness of the salary deduction may also be raised by the IRS in connection with services of family members.
It is possible for an LLC to be taxed as a C corporation despite not technically being a corporation under state law. The separateness of the corporation has well-known non-tax implications, such as its general ability to shelter the owners from liability.
Limited liability is an important consideration, often a critically important non-tax consideration. If the one who slipped and fell did so going through the corporation’s door, he or she generally can’t sue the shareholder(s).
There are benefits but also added costs. For example, there is generally an $800 minimum payment to California’s Franchise Tax Board for the privilege of incorporating. The fee also reaches S corporations, as well as LLCs and other entities.
It is possible for a C corporation to qualify as an S corporation despite its history as a “regular corporation.” Yet it is possible for the flow-through of income normally associated with the S election to trigger corporate tax under the built-in gains tax rules (Section 1374).
In general, the built-in gains rules can reach appreciation realized during the first five years of the S election in the case of a former C corporation. Installment reporting during those five years doesn’t necessarily circumvent the built-in gains tax problem. So, C corporation status may not “turn off” quickly in certain respects.
The Corporation’s Distinct Tax Rates
The Tax Cuts and Jobs Act of 2017 (TCJA) made a permanent reduction in the corporate tax rates, introducing the singular 21 percent federal corporate tax on business as well as investment income. We’ll not focus on the estate and trust tax rates since that is rarely the comparison.
Also, the estate and trust income tax often be avoided by means of distribution deductions. Such entities normally qualify for distribution deductions that flow-through income to the beneficiaries. The tax rate comparisons usually focus on the corporate rate of 21 percent relative to the individual rates.
Despite all of the extraordinary steps for financial relief in our 2020 coronavirus pandemic environment (writing in May 2020), there has been no suggestion so far of individual or corporate tax rate relief. Accordingly, the 2020 individual rates still start at 10 percent and reach 37 percent, relative to the flat 21 percent corporate tax rate.
The individual brackets are seven: two of which are well below the corporate rate. These are the 10 percent and 12 percent brackets. The third and fourth brackets of 22 percent and 24 percent exceed the corporate rate, but one would judge not materially so, keeping in mind corporations entail some incremental expenses.
The fifth, sixth and seven individual brackets of 32 percent, 35 percent and 37 percent are significantly higher than the corporate rate. It is at such income levels when shifting incremental income to a corporation might seem strategic.
We note generally the beginning income levels of the fifth bracket are as follows for the various filers: $163,300 for singles, marrieds filing separate and heads of household, versus $326,600 for joint returns.
In general, don’t shift so much taxable income to a C corporation that the incremental income is taxed at a rate higher than would be the case in an individual return. Also, don’t shift so much taxable income to a C corporation that deductions get wasted in the Form 1040.
For example, one’s personal exemption doesn’t increase a net operating loss (NOL) and is usually wasted if not utilized in offsetting current income in the Form 1040. In general, don’t shift deductions to a C corporation such that they simply translate into NOL carryforward.
On the other hand, we note that an individual owner’s NOL carryovers may expire unused at the owner’s death, whereas a corporate net operating loss normally survives the death of the owner or owners. Keep in mind that “shifting” income and deductions to the corporation needs to have substance.
Details, Details and More Details
There are many particular, individual provisions that are more liberal depending on that individual’s (of the couple’s) level of income. Such provisions may be affected by whether there is income inside or outside of a corporation.
The CARES Act recovery rebates of generally $1,200 individually and $2,400 on joint returns have a phase out beginning at $75,000 of adjusted gross income or $150,000 of AGI on a joint return. Such payments, tax-free income, might well have been affected by having earned income in a C corporation versus one’s individual return.
- In “doing the math” for a particular taxpayer, keep in mind such factors as the following:
- The business income in an individual return may qualify for the 20 percent of business income deduction (Sec. 199A)
- There is no long-term capital gains break on income inside of a C corporation
- C corporations entail a certain level of expense, including CPA fees, legal fees, and at times tax research. The most well-known treatise on corporate tax is the Federal Income Taxation of Corporations and Shareholders which sells for over $1,000. Incorporating introduces corporate taxation, which can be complicated.
- Individuals are generally limited to $10,000 maximum itemized deduction for state income taxes but this limit doesn’t apply to C corporations.
- Generally consider keeping such assets as business realty outside of the corporation, and renting the assets to the corporation. This is most often associated with keeping major gains outside of corporate solution due to the double taxation effect.
- Multiple corporations may be appropriate for any number of reasons, including legitimate business reasons. Multiple corporations raise the topic of brother-sister arrangements versus intercorporate ownership. In general, the consolidated return privilege looks to 80 percent common ownership within the corporate group. Consolidated returns, for example, generally permit losses within the group to offset income of other members of the group.
- Factor in the extra work as well as extra expense. The “extra work” occasioned by having a C corporation includes keeping track of earnings and profits, which affects the measure of taxable dividends.
- A new corporation has no history and so no carryback capacity. In stressful, complex economic times as we are now experiencing in early 2020 with the coronavirus pandemic, one important factor to consider is the inability to carryback net operating losses. An individual may well have significant carryback capacity. The recent 2020 legislative changes significantly liberalized the ability to carryback net operating losses.
- Factor in the long-term perspective, including what may impact planning for the eventual sale of the business. Another important factor in the analysis is keeping a perspective of the owner’s longevity. For example, when an individual passes owning a privately-held C corporation, the basis in the stock may well step-up at death, assuming appreciation. Realty owned by the shareholder and rented to the corporation may also have basis step-up (Section 1014). On the other hand, appreciated assets inside the C corporation don’t step up.
Weighing the tax aspects of incorporation is inherently complex but business owners and their advisers need to carefully weigh and assess the more important factors. This is process is inherently complex is more normal times, even more so in these difficult times.
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Mike Pusey, CPA is National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in audit and...