C Corporations

By Jason Watson, CPA

The big knock on C Corps is that they might be tax inefficient. Wyoming was the first state allowing LLCs in 1970, but most states did not follow suit until the 1990’s. Therefore, if you wanted to avoid double taxation you had to first create a C corporation and then elect S corporation taxation.

Thanks to current tax law changes, corporations now enjoy a 21% income tax rate. But… not all that glitters is gold. Dividends are then taxable to you up to 23.8% (which is 15% to 20% capital gains plus 3.8% of Medicare surtax potentially). Therefore, your effective tax rate for using a C Corp as your entity choice ranges from 36% to 44.8% where the top individual rate of an S Corp shareholder is 37%. This is the double taxation part.

Not all is bad with C Corporations.

C corporations generally enjoy better financial liability protection and have much easier transfer of ownership. Taxes are paid at the corporate level to the IRS and states (either through an income tax or a business tax) on Form 1120. Notice the subtle difference; 1120 and 1120S.

Because of the relatively low tax rate as compared to the highest individual tax rate, C Corps can leverage debt reduction at a cheaper rate. How? You buy a piece of equipment with a loan. A portion of the loan payment is principal and is basically paid with after-tax dollars since the interest portion is deducted. Said in another way, you make $1,000 in profits and use $1,000 of it as accelerated debt reduction. You will still pay tax on the $1,000. Yuck.

So, the question becomes, if you must pay taxes on the $1,000, would you rather do it at 21% than 37%? We’ll give you a minute to decide with an optional chin rub. Again, this is predicated on smart budgeting and using excess cash to pare down debt versus that European cruise you’ve been eyeing.