[IMGCAP(1)]One of the first, and perhaps most important, decisions a business owner initially makes is the type of business entity to select.
Many closely held businesses have been organized by their owners as subchapter S corporations as opposed to C corporations. While both provide liability protection, there are several important tax and employer benefit considerations unique to each structure.
Many business owners incorporate as an S corporation to take advantage of the losses a business may initially incur at the individual level. However, arguably the best-known income tax advantage of an S corporation over a C corporation is that the K-1 distribution, or the amount of profit in excess of the W-2 compensation, is not taxable at the corporate level.
Furthermore, the K-1 distribution paid to the shareholders is considered a dividend and therefore not subject to the Medicare tax and other payroll taxes. Another tax advantage of an S corporation is recognized upon the company’s sale, liquidation or ownership transfer to a future generation, as most buyers would prefer an asset sale over a stock sale.
However, there are many benefits of electing a C corporation structure over an S corporation. This type of entity structure should be looked at much more carefully and utilized more frequently by owners of closely held businesses. The principal income tax advantages of a C corporation are the availability of various fringe benefits and deferred compensation programs to the shareholders and employees. There are other advantageous benefits as well.
Invariably, when discussing the advantages and disadvantages of a C corporation, the issue of “double taxation” will almost always be foremost. Proponents of S corporations will point this out as a major reason to avoid utilizing a C corporation. “Double taxation” can occur as profits are first taxed to the C corporation. Then, when they are distributed to shareholders they are considered dividends and taxed again.
The C corporation cannot deduct the dividend payments to shareholders. This is a valid point; however, there are a variety of ways to mitigate this issue. One way is to reduce the amount of income as reported by the corporation as close to zero as possible, and therefore the amount of tax paid will be negligible, as will the issue concerning dividends and “double taxation.”
Other ways to accomplish this task include taking deductions to reduce income via salaries and expenses; having family members on the payroll, as long as they are legitimate employees; borrowing; and leasing goods and equipment via another controlled entity. The use of multiple entity planning to shift and deduct income to another entity for real and substantial business purposes, if possible, can also be an excellent tool. Of course, specific rules must be adhered to when engaging in this type of planning.
Another advantage of a C corporation under the current tax law involves long-term care insurance. Owners of closely held businesses can benefit tremendously from a qualified stand-alone long-term care insurance policy. However, when the business pays the premium for a shareholder-employee who owns more than 2 percent interest of a S corporation, that shareholder-employee can only deduct what is deemed the “age-eligible” premium (defined as a medical expense in Section 231(d)(1) and Section 213(d)(10) of the IRC).
The non-deductible portion of the premium for a long-term care insurance policy is included in that shareholder-employee's gross income. The benefits of the policy are tax-free. In a C corporation the advantage of the business paying the premium is much greater for the more than 2 percent shareholder-employee.
The C corporation pays the premium, 100 percent of which is deductible, and none of it is considered taxable income. The benefits of the policy are tax-free as well. In either scenario the long-term care insurance policy can be offered selectively to the shareholder-employees and non-owner key employees without covering any other employees.
Furthermore, shareholder-employees who own more than a 2 percent interest in a C corporation can possibly exclude up to 40 percent of corporate paid contributions to a Section 79 plan from personable taxable income. A Section 79 plan can offer powerful tools for both the owners and employees. This benefit plan, when funded with permanent life insurance policies as well as group-term life insurance, offers valuable benefits including significant survivor benefits and a source of tax-free retirement income.
The C corporation can offer the additional advantage of being able to utilize a medical reimbursement program as well. The advantage to the business is a full deduction for qualified medical expenses incurred for those eligible to be in the plan. Concurrently, the shareholder-employee who owns more than 2 percent interest or any other employee does not have to recognize that amount as income.
One little known but powerful advantage of a C corporation involves financing a new business or acquiring a business using rollover funds from a retirement account. This is a Rollover as Business Startups (ROBS) Plan, also known as a Business Owners Retirement Savings Account (BORSA).
There is also a system designed for this purpose called an Entrepreneur Rollover Stock Ownership Plan (ERSOP). For those tax, legal and financial advisors who have clients interested in owning their own businesses, and who have a significant amount of assets in retirement accounts, a ROBS can be a powerful tool in financing a new business. There are very specific guidelines that must be followed. A ROBS, and this type of planning, will only work in conjunction with a C Corporation and will not work with other forms of business ownership.
Finally, it has been theorized by some that use of a C corporation will increase the chance of a random general corporate audit by the IRS. There are those in the tax and legal community who are proponents of this thinking and will state that this type of entity is under more scrutiny and therefore has a higher chance of being randomly audited than S corporations.
This cannot be proven and the argument can be made that this is not true. For example, when I spoke with several partners of a major national accounting firm, their opinion was that this is simply not accurate. They stated that no one knows for certain what precipitates a random general corporate audit. They theorize that the business’s SIC (Standard Industrial Classification) code is possibly the overriding factor, in addition to specific areas that the IRS chooses to focus on at different points in time.
The C corporation continues to be a powerful, yet under-utilized, entity. Those looking to form a new business, acquire a business, or currently using a pass-through entity should consider the advantages of a C corporation for their business structure.
Brian D. Hartstein, MSFS, CLU, ChFC serves as CEO and principal of Economic Concepts, Inc. in Scottsdale, Ariz. He concentrates primarily on working with CPAs, financial advisors, successful business-owners and affluent clients in the qualified and non-qualified plan markets, estate planning and financial and investment planning. He is currently on the advisory board of the Phoenix Tax Workshop, a member of the Society of Financial Service Professionals, a member of the Arizona Business Leadership Association, and served as president of the Financial Planning Association of Greater Phoenix.