C Corporation can be a tax trap! “C” Corporations taxable income is paid at the corporate level. “S” corporation and partnerships in most cases do not pay tax but instead the taxable income flows down to the personal return where the income is taxed. With the new higher personal tax rates that can exceed 40% for federal income taxes, clients are asking if there is way to reduce their taxes by changing their tax structure from an S corporation or a partnership. Their question is good because the S corporation and partnership profits flow through to their personal tax returns and are added to their other income including their W-2s. Marginal tax rates increase as all of the income is added together!
A few clients have asked about changing to a C “regular” corporation because they have heard that the corporate tax returns are lower than individual tax rates. Although C Corporation tax rates are lower than individual tax rates on the first $75,000 of taxable income for non-professionals like dentists, doctors, lawyers and other professional who get paid fees, the C Corporation can be a trap that is hard to recover from. The good news is that the tax rates are only 15% on the first $50,000 and just 25% on the following $25,000. But what if IRS audits the tax return and finds an additional $25,000 of taxable income so taxable income is $100,000 instead of $75,000?
The tax assessment would be $9,750 on the additional $25,000 taxable income. In addition, there would be additional assessments for underpaying estimated taxes and late payment penalties. The total cash outlay including the state tax and penalties would exceed 50%. A C Corporation taxable income has to be planned carefully to avoid having more than the $75,000 because taxable income between $75,000 and $100,000 is taxed at 39% tax rate. There has been a lot of talk about C Corporation tax tops rates being reduced down to 25% for manufacturers and 28% for other businesses (excluding professionals). Right now this is just a lot of talk and may never occur. If the C Corporation tax rates are actually lowered than converting a C Corporation is worth reconsidering. In addition, what happens when you sell your business as an “asset sale” and the buyer buys the goodwill and assets of your business? All of the income from the sale will be ordinary income and none will be capital gains income. Then the corporation has to “liquidate” for tax purposes and dividend income will be taxed on the personal tax returns. Therefore, there is tax at the corporate level and again on the dividend income required to be reported on the liquidation of the corporation. If you delay the liquidation to avoid the dividend income, the IRS can assess what is called a “personal holding tax of 39%. The C Corporation tax benefits are few. Long-term care premiums are 100% deductible. Disability insurance premiums are deductible but if disability occurs, the proceeds are taxable. These benefits are not worth selecting C Corporation tax status. Although the top tax rates for individuals are now higher than the C Corporation higher tax rates, C Corporations that are extremely profitable and have a high amount of goodwill value should not be converted to a C Corporation because of the double taxation occurring when the corporation is liquidated.
If instead of taxable income on the liquidation on the C Corporation there is a remaining net operating loss at the corporate level, this tax benefit cannot be used to offset personal income. Tax reduction CPA thus become handy in this situation. Some losses are disallowed. Your corporation may not deduct a loss on property it acquired as a contribution to capital or which it acquired in a tax-free transaction, such as property you transferred in exchange for stock when you formed the corporation. Goodwill that you created has no investment cost basis. When selling the business, all of the goodwill will be ordinary income instead of capital gain at the corporate level because C Corporations do not have the benefit of the lower capital gains tax rates. The key is to make sure in the agreement that most of the goodwill is allocated to you personally instead of your corporation. They buyer doesnâ€™t care how much goodwill is allocated to the business versus the seller because the tax effect to the buyer is not impacted either way. Many sellers have large capital losses from the 2008 bear market that they can use to offset the capital gain from the goodwill sold to the buyer.
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