Tax implications are among the most important factors to think about when deciding on a business entity type. Some business owners are attracted to the simplicity of pass-through taxation, which is how a sole proprietorship, partnership, LLC, and S Corporation are taxed. But for others, the tax benefits of incorporating as a C Corporation offer more financial advantages.
What’s right for your business? We encourage you to ask that question to an experienced business accountant or tax advisor who understands your situation and can give you professional tax advice tailored to your circumstances and goals. As you prepare to start a business or convert an existing business, below is some general information about how corporations are taxed and some of the potential tax benefits of incorporating a business.
How a Corporation is Taxed
A C Corporation is a business entity independent (both legally and from a tax perspective) of its owners (called “shareholders”). As such, the company is responsible for reporting its profits and losses on its own income tax return and paying any income taxes due. Shareholders do not pay individual income tax on all company profits (as is the case with pass-through entities, such as sole proprietorships, partnerships, LLCs, and S Corporations). Still, they must report their wage and salary income as well as any dividends the company paid them on their individual tax forms. You’ll often hear “double taxation” used to describe how a C Corporation gets taxed. That term captures how profit distributions to shareholders are taxed at the individual taxpayer level and at the corporate level (because they are not deductible as an expense to the business).
Potential Tax Advantages of Incorporating as a C Corporation
1. Attractive Corporate Tax Rate
The Tax Cuts and Jobs Act of 2017 lowered the federal corporate tax rate from 35% to 21%.
Having their company taxed at that reduced corporate rate may work in favor of business owners who would be in one of the higher individual tax brackets if the business were treated as a pass-through tax entity. Rather than all profits flowing through to the owners’ income tax returns, only their salaries and dividends pass through to them (thus potentially putting them in a lower individual tax bracket).
2. Wages, Salary, and Bonus Deductions
A C Corporation may deduct its payroll expenses, including wages, salaries, and payroll taxes (it pays half of its employees’ Social Security and Medicare taxes) to reduce its taxable income.
Some corporations use this to their advantage by paying shareholders who work in the business generous (but reasonable for their work) salaries, thus leaving little remaining profit to be distributed as dividends. Since payroll is an eligible business tax deduction and dividends are not, doing so helps to reduce a C Corp’s taxable income.
3. Tax Deductible Employee Benefits
A C Corporation may deduct many of the fringe benefits that they pay to their employees and shareholders. Under most circumstances, unincorporated businesses are not allowed to do so. Therefore, this gives entrepreneurs who establish C Corps another opportunity that other entities don’t have to lower their tax liability.
Some of the benefits that may be eligible as deductions for a C Corporation include health insurance premiums and retirement plans. Provided a C Corporation makes its fringe benefits available to all employees, it may typically deduct those expenses from its taxable income.
4. Deferment of Net Operating Loss
According to the IRS, if a C Corporation has a Net Operating Loss (NOL), it may be able to carry that loss back or forward. This may be advantageous because it spreads out the loss, lowering the company’s taxable income over several years rather than only in the year that the loss was incurred. Per the CARES Act, NOLs incurred in tax years ending after 2017 and before 2021 generally can only be carried backward. The NOL is limited to 80% of taxable income (calculated without regard to the net operating loss) for losses arising in tax years beginning after 2017. However, the IRS has temporarily lifted that 80% income limit for NOLs in tax years 2018 through 2020.
This facet of corporate tax law has undergone much ebb and flow over the past few years, so it’s wise to watch for IRS updates and get guidance from a tax advisor about its current form.
5. Fiscal Year Flexibility
Sole proprietorships, partnerships, and often S Corporations have a tax year that coincides with the calendar year. C Corps, however, have flexibility in determining their fiscal year (tax year). By having more control over when the business’s tax year begins and ends, for example setting a fiscal year of July 1 to June 30, a C Corporation’s shareholders may be able to lessen their tax obligations by having the Corporation pay bonuses or dividends in the first half of their fiscal year (which would fall in one calendar year) or in the second half of their fiscal year (which would fall in the next calendar year).
6. Expanded Interest Deduction
Currently, as a result of a provision in the CARES Act, C Corporations may deduct 50% of their net interest on business debt in 2019 and 2020. In 2017 and 2018, that amount was previously capped at 30% of the business’s adjusted taxable income (ATI), which might still provide a significant decrease in tax liability for C Corps if that cap resumes after 2020.
7. Charitable Donation Deduction
Most business entities may not deduct charitable donations to lower taxable income, but the C Corporation is an exception. The deduction amount is limited to 10% of a C Corp’s annual pretax income. Generally, C Corps, may carry forward excess donations for five years. In some cases, a C Corporation’s charitable contributions may qualify as business expenses.
Note that in 2020, The CARES Act temporarily raised the deduction limit to 25%of the C Corp’s pretax income. The CARES Act also raised donations of food inventory from 15% to 25%.
8. Flexibility in How Owners Are Paid
By incorporating as a C Corp, business owners only have to pay Social Security and Medicare taxes on the wages and salaries they personally receive. Dividend income is not subject to those taxes. This may save them money on the individual tax front because they don’t have to pay those taxes on all business income like a sole proprietorship, partnership, or LLC does.
Or, the business owners may decide not to pay dividends and instead leave profits in the C corporation for further expansion of the business, which could have tax advantages. For example, if the shareholders have high personal income tax rates and don’t currently need dividends from the company, they can leave money in the business to avoid getting hit with additional individual income tax. This may make the C Corporation structure more attractive than operating as a sole proprietor, partnership, LLC, and even an S Corporation. When running a business under one of those entity types, business owners pay income tax on all profits, even if they personally do not take distributions.
Incorporate Your Business With CorpNet’s Help
Tax laws are constantly changing, so enlist the help of an attorney, accountant, or tax advisor to help you understand the current rules. After you’ve explored which business structure will be best for your business, contact us.
CorpNet is here to prepare and file all of your business registration paperwork and other forms, saving you time and money. Call us today!