When a C Corporation is Best for Small Businesses
Choosing the right business structure is crucial for small business owners. While S corporations and LLCs are popular choices, there are specific scenarios where a C corporation might be the best option. This article explores when a C corporation is advantageous for small businesses, despite the common preference for S corporations and LLCs.
Understanding C Corporation Taxation
C corporations are subject to double taxation. This means profits are taxed at both the corporate level and the shareholder level. Here’s a simplified example:
- A C corporation generates $10 million in revenue and incurs $9 million in expenses, leaving $1 million in profit.
- The corporation pays income tax on this $1 million profit.
- If the profit is distributed to shareholders, they must also pay income tax on the amount received.
Advantages of S Corporations
S corporations avoid double taxation. Profits flow directly to the owners and are only taxed at the shareholder level, making this structure generally more tax-efficient for small businesses.
Situations Favoring a C Corporation
While the double taxation aspect of C corporations is usually a disadvantage, there are situations where a C corporation can be beneficial:
Deductible Expenses
C corporations can deduct certain expenses that S corporations and LLCs cannot. These include fringe benefits, insurance, and other specific expenses, potentially reducing taxable income.
Retained Earnings
A significant advantage of C corporations is their ability to retain earnings within the company without distributing them to shareholders. This scenario is ideal for business owners who:
- Do not need to withdraw profits for personal use.
- Prefer to reinvest earnings into the business.
- Aim to increase the company’s value over time.
Example Scenario
Consider a business owner who lives a modest lifestyle and has other income sources. This owner may choose to leave profits in the corporation, reinvest in the business, or support other ventures. By not distributing profits, they avoid the second layer of taxation at the shareholder level.
Estate Planning and Stepped-Up Basis
When C corporation shares are inherited, the recipient benefits from a stepped-up basis. This means the value of the shares is reset to their market value at the time of inheritance, potentially avoiding significant capital gains taxes.
For example:
- An owner invests $1 million in a company, which grows to be worth $10 million.
- Upon the owner’s death, the shares are inherited with a basis of $10 million.
- The heirs do not owe taxes on the $9 million gain, which they would if the shares were sold during the owner’s lifetime.
While C corporations are often less favorable due to double taxation, they offer unique benefits in specific situations. Business owners who do not need to withdraw profits and prefer to reinvest them, or those looking to pass on business value tax-efficiently, may find C corporations advantageous. Understanding these nuances helps small business owners make informed decisions about their business structure.
Video Transcript
Business Structure Considerations
I am a business attorney, and I recently had a conversation with a client where I recommended a C corporation. Admittedly, that is pretty rare because most of the time small businesses should be an S corporation and sometimes an LLC. But it is rare to be a C corporation, and here is why.
Tax Implications of a C Corporation
C corporations get taxed twice. Once at the corporate level, once at the shareholder level, or at the owner level. So in other words, let’s say a corporation, a C corporation, has $10 million in revenue, and $9 million in expenses. And so the remainder is $1 million in profit. When a C corporation has $1 million in profit, it must pay income tax on that profit.
Now let’s say that corporation passes that profit on to shareholders. The shareholders then have to pay income tax on that money received. So in a C corporation, profits are taxed twice. One at the corporate level, and one at the shareholder level.
S Corporation Advantages
So usually, it is better to have an S corporation. In an S corporation, the profits from the company flow right through to the owner. They are not taxed at the corporate level, and they are only taxed at the shareholder level. So as you can see, most of the time, from a tax perspective, an S corporation is advantageous.
When a C Corporation is Beneficial
But there are a couple of times when a C corporation is best. That is what I am going to talk about here. First off, there are some things that a C corporation can deduct that an S corporation or LLC cannot. A company can always deduct expenses for the employees who are not shareholders. But in an S corporation and an LLC, you may be limited in whether you deduct certain sorts of fringe benefits, insurance, and some of the other expenses that you may have, but in a C corporation, you are permitted to do that.
Major Reason for Choosing a C Corporation
So that is one example. That usually isn’t the major reason, though. This is the major reason. A C corporation may be generating so much money that it is never going to move that money into the shareholders. Let’s talk about that. It is often called retained earnings. So if the C corporation gets money and retains that money, sure, they will have to pay tax on it once, but they are not passing it along to the shareholders.
Retained Earnings and Reinvestment
What often happens is the shareholders are not interested in pulling the money out and getting taxed on it. They would rather leave that money in the company, which increases the value of the shares, and the company reinvests that money in other business opportunities. That was the scenario I ran into recently.
Real-Life Scenario
My client has a business and doesn’t need the money from the business. He is very frugal. He does not live a lavish lifestyle. He keeps things simple. He is a minimalist. And as a result, he doesn’t need a whole lot of money to live. And he also has some other sources of income from his job. So, this client of mine has these business ventures, and he desires to help people with them, help employees, help friends of his who want to start companies and create a community that fosters supporting each other, reinvesting, and helping people, and making a big difference.
Long-Term Financial Strategy
That is what gets him excited. That is what gets him out of bed every day, along with what he is doing in his other job. But the bottom line is, let’s say you have a corporation, and you are not going to need the profits distributed to you. Well, rather than having an S corporation where you have to pay tax and all the profits at the shareholder level, you can use the C corporation level.
Yes, you are going to have to pay some tax, but it is not as much as if it were passed along to you. And then once those profits are sitting in the company, those earnings, are retained for future reinvestment. So one of the reasons a business owner might want to have a C corporation is because the owner doesn’t plan to pull a lot of the earnings or profits out of the company. The owner wants to change the world, make a difference, and use those profits to start new businesses and take advantage of new opportunities. In that case, there are going to be lower taxes in a C corporation than there would be in an S corporation because the tax or the profits are not being passed down to the shareholder, who then has to pay a higher rate.
Taxation Nuances and Future Planning
And you might say, “But I thought a C corporation gets taxed twice? Once at the corporate level, once at the shareholder level.” That is normally true. But if you never distribute the profits to the shareholders, then they are not having to pay tax at that level. The profits sit in the company and get reinvested and reinvested.
Now you might say, “Well, eventually, what happens?” Well, usually people die. We all die. At that point, their shares in the company go to whoever they want to pass them on to in their estate plan. And usually, the recipient of those shares gets them in what is called a stepped-up basis. That is a legal or tax term. I am going to explain it to you, but the bottom line is they don’t have to pay tax on the shares that they have received. And if they sell those shares, they don’t have to pay tax on that. It is essentially considered a gift.
Understanding Stepped-Up Basis
So here is what a stepped-up basis is. Let’s say that you put a million dollars into a company. That company has a basis of a million dollars. And so that is what you, or maybe you, spent on the shares of the company. Million shares for a million dollars, $1 per share. All right, and you are the only owner of the company, so you own the whole thing. The company now has a million dollars in cash in it. You have a million shares.
Let’s say, though, that the company generates profits over time, and let’s just say it earns $9 million in profits over the life of the company before you pass away. And it has to pay tax on that $9 million, but it keeps that $9 million as retained earnings. Well, now the company has your million and the $9 million in retained earnings. That is a total of $10 million. So that company now is worth $10 million. In other words, the shares that you paid a million dollars for are worth $10 million. So there is a difference of $9 million between what you paid for the shares and today’s value of the shares.
Capital Gains Tax Implications
Now, normally, if you sell those shares, you are going to have to pay capital gains tax on the money when you get it, but if you transfer that $10 million in shares, let’s say to your child, your child gets those shares with what is called a stepped-up basis. So instead of saying the basis is a million dollars, which is what you paid, the basis becomes $10 million, and there is no tax bill associated with that.
It is a huge loophole if you want to call it that in the tax code, or it is a huge feature, whichever perspective you want. The idea, though, is that a certain amount of money can be passed on to heirs in your lifetime tax-free, and the heirs get shares in a company on a stepped-up basis, so they don’t have to get it and then pay a huge tax bill on it.
Legislative Considerations
You might say, “Well, why does Congress allow that? Shouldn’t that be changed?” Well, here is the argument against it. Let’s say you inherit $10 million in shares from your grandpa. And let’s say you decide you would like to hold onto those shares and maybe pass it on to your kids. Well, if you immediately owe a tax bill on that, let’s say your tax bill is $4 million out of $10 million, you are going to have to sell shares because you don’t have that kind of money sitting around.
So the idea is that we want citizens to be able to pass on at least a certain amount of inheritance without the children or grandchildren having to sell part of the inheritance to pay the tax bill for that. That is why the stepped-up basis is available.
When a C Corporation Makes Sense
So going back to the big question here, “When would a business owner want a C corporation?” Well, if they are not going to have to pull a lot of money out of the company and they plan to just accumulate wealth or retain earnings, keep all of those profits, and then pass that on or donate something to a charity, that is a great example of when a C corporation will cost less for the owner. Thus, the owner will pay less in taxes with a C corporation than the owner would with an S corporation or an LLC taxed as a sole proprietorship.
About the Speaker
I am Aaron Hall. I am an attorney for business owners and entrepreneurial companies. My goal is to help business owners avoid problems, minimize taxes, stay out of trouble, and focus on what is most important to them. Running a thriving company. If you would like to learn more about how to avoid problems in your company, I have a resource available. It is available at no charge. You can find it at AaronHall.com/free. If you go there, you sign up, and you will get a PDF with some of the common legal problems faced by companies. You will get some videos with me explaining how you can save money on those. There is no charge for that.
Upcoming Topics
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