Don't Be Fooled by These C Corp. Fairy Tales
In my opinion, the C corp is one of the greatest pitfalls in tax planning for the small-business owner, and it astonishes me how many lawyers promote it. If they want to sell setting up a new corporation, that’s fine. However, I wish they’d sell the S corp, which might actually help people achieve their business goals.
Essentially, there are three myths used to sell entrepreneurs C-corp packages they don’t need:
- The myth of extra tax deductions
- The myth of lower corporate tax rate vs. personal tax rates
- The myth that they can avoid the double-taxation problem with a higher salary
Let me briefly address each of these myths and suggest you use them as a starting point for a mindful consultation with your CPA or tax attorney.
Myth 1: Extra C corporation tax deductions
Advocates for the C corp will contend that because of all the entity’s extra tax deductions, you’ll be able to dramatically reduce your net income far more than you could with any other type of entity. The rule is that if you own more than 2 percent of an S corp, neither you nor your spouse can take the following write-offs:
- Disability insurance
- Health reimbursement arrangement
- Day-care assistance plan
- Educational assistance program
- Cafeteria plan
However, consider that 1) not everyone can use these write-offs anyway; 2) they don’t add up to enough to make a long-term difference; and 3) if you have other employees, you have to give them the same benefits you receive in order to take the deductions.
Can you afford to and are you planning to purchase disability insurance? Do you have kids in day care, or are you going back to school and need a write-off for tuition besides the other available education write-offs (such as the lifetime learning credit)? Are you aware that you can write off health-care expenses in other creative ways using a Health Savings Account (HSA) or Section 105 Health Reimbursement Arrangement? And finally, have you thought about how much it will cost you to provide these fringe benefits to other employees you may have?
To be fair, I’ll take a leap of faith and assume you can get $15,000 more in write-offs in your C corp that you couldn’t get anywhere else--an assumption, I think, that’s extremely aggressive.
First, let’s compare an S corp and a C corp with the same income and expenses before we add any expenses to the C corp strategy. Assume you have $100,000 in gross income, $25,000 in general expenses, and thus $75,000 of net income. Then you take out your salary of $25,000, which you would have to do in both an S corp and a C corp. This leaves you with a $50,000 dividend taxed at a 21-percent corporate tax rate -- before you take your dividend and are then taxed again on your individual return.
But what if the C corp digs up $15,000 more in expenses? I strongly disagree that the average business owner is going to be able to find $15,000 more in expenses. These types of expenses are extremely unique, especially when you take the health care expense out of the equation. But nonetheless, I’ll give these gurus the benefit of the doubt to still make my point.
The fact is, an individual will pay a flat 15 percent tax on the qualified dividends from the C corp. However, coupled with the 21 percent tax rate on the C corp profit “before” dividends, the double-tax is a killer. Thus, ultimately S corp wins the tax savings battle ... and furthermore, the more money you make the more you save with the S corp.
Myth 2: The Lower C corporation tax rate
If eliminating all corporate income via deductions doesn’t work (and it won’t), a C corp promoter will try to convince you that because the C corp only has a 21-percent flat rate tax on all of its net profit--and thus possibly a lower rate than personal income tax rates-- you’ll somehow experience savings. This is a shell game you can lose quickly if you aren’t careful .
To effectuate this savings, the guru will suggest you pay the corporate tax and leave the money in the C corp so you don’t pay the double tax (your personal income tax) when you pull the money out. The problem with this plan is the ultimate outcome: Your money will be stuck in the corporation. You’ll only be able to loan yourself the money, at best. Someday you’ll want that income, pull it out of the corporation or zero out any loans, and then have to pay individual income tax on the retained earnings or distributions. Leaving the money only delays the inevitable.
Furthermore, when you consider the new 20-percent 199A pass-through deduction on S corp net income, the tax savings of an S corp is even greater compared to that of a C corp and savings that might exist between the corporate and personal tax rates.
Myth 3: The higher payroll solution
Ultimately you plan to make money with your company, right? After all these incredible C corp deductions, how are you going to take that profit out and not pay double tax? More salary? If you take a loan, the taxes will hit like a ton of bricks when you eventually shut the C corp. It’s a ticking time bomb!
Where are you going to hide all the profit you plan on making? Invariably, when the C corp advocate is faced with the corporate income issue, they’ll suggest taking a greater payroll to wipe out the income.
But if you take a larger salary to wipe out the net income of the corporation, what do you pay more of? Payroll tax! In the S corp, you could take a lower salary and not have any corporate tax on the net, so obviously the S corp wins this argument as well.