Since taxation of a C corporation is based on its earnings, while S corporation shareholders are subject to personal income tax based on the company’s earnings, it might make sense to be taxed as a C corporation subject to the lower corporate tax rate. Not necessarily so, said John Evans, CPA, a partner in the tax group at New York-based Marks Paneth & Shron LLP.
“The smart move will be to avoid that immediate, knee-jerk reaction,” he said. “You may think you’re lowering your tax obligations by being a C corporation and have the company pay the taxes at a lower rate. The reality is you’ll still probably save by remaining or becoming a flow-through entity such as an S corporation.”
There are a number of reasons why the owners of a growing company should retain its S designation, according to Evans.
“Double taxation of corporations is what I see most people miss,” he said.
Evans provided a few examples to illustrate the continued advantage of operating as an S corporation:
“Say an accrual basis company earns $1,000,000 in profit. If it’s a C corporation, it pays $350,000 in income taxes. Its shareholder also pay a 23.8 percent tax on the retained earnings when they are distributed, so there are two levels of tax that reduce the shareholders’ net cash distribution to $495,000. If the company is an S corporation, the income flows through to the owners, who pay as little as $396,000 in income tax. The S corporation owners are left with $604,000, or $109,000 more than the C corporation owners.”
Double taxation surfaces again if and when the business is sold, Evans observed.
“If it’s a regular corporation and it sells its assets, there is gain at the corporate level, and then tax is paid again when the proceeds are distributed to shareholders,” he said.
“Say a company finds a buyer for all its assets and one of the assets to be sold is self-created goodwill with a fair market value of $5 million and no tax basis,” he said. “If it’s a C corporation, it is subject to $1.75 million in corporate taxes. The remainder is distributed to the owners who must then pay $774,000 in capital gains tax on that amount.”
However, the result is more favorable if the company is an S corporation, Evans indicated. “In the case of an S corporation, the $5 million flows through to the shareholders as a capital gain and they pay $1 million in taxes. The S corporation owners are left with $4 million after taxes, while the C corporation owners are left with approximately $2.5 million—a savings of $1.5 million in taxes as a result of operating as an S corporation.”
As with all tax planning, people shouldn’t make quick decisions to change their entity based solely on tax rates, since the result may be different when they run the numbers.
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