Though C corporations are not known for being tax advantaged, these entities do come with hidden benefits if you know where to find them. If you’re a business owner in a high tax bracket, the flat 21% corporate tax rate can be an attractive perk. However, this can also lead to the temptation to leave income in the business eternally, since distributions get hit with a second layer of tax. “Holding” income in a C corporation can be an effective strategy if you’re simply looking to control the timing of those distributions. But if you try to use a C corporation as a vehicle for hoarding wealth, like a dragon guarding its treasure, you can’t escape the IRS. A little provision called the “personal holding company tax” prevents business owners from hiding income in their C corporations.
Don’t Get Hit With That 20% Federal Penalty Tax!
If you’ve never heard of the personal holding company tax, then perhaps you have never attempted to stockpile money in a C corporation without distributing it. This tax is designed as a deterrent to that type of behavior. A C corporation is not meant to be a tax avoidance tool for stockholders. So if a taxpayer is caught trying to circumvent the rules here, they could end up paying, not only the original 21% corporate tax but an additional 20% tax on that undistributed income.
To ensure you don’t get a hit with an unexpected penalty tax, you first need to understand what the IRS views as a personal holding company…
Do You Pass the Two Tests?
The IRS determines if your C corporation is a personal holding company based on two tests:
- The stock ownership test: This test asks “Is more than 50% of the corporation’s stock owned directly or constructively by five or fewer individuals?” So if you have a small, closely-held business, you may be on the brink of “personal holding company” status. Direct ownership is easy to determine because the business owner holds their share in their own name. “Constructive” ownership is a bit trickier. This refers to indirect ownership outside of individuals who simply have stock in the company, and it can include spouses, children, parents, siblings, partnerships, trusts, and estates.
- The income test: This test asks, “Does at least 60% of the company’s adjusted gross income (AGI) consist of passive income?” Under these rules, passive income includes any investment earnings, interest, dividends, royalties, annuities, rents, and any income where the owners are not materially participating. Some businesses may qualify for an exception when it comes to rent or royalties if specific active trade or business thresholds are met.
How might business owners fall into the personal holding company tax trap? Say a business owner has been taking most of their earnings and reinvesting that money in stocks, bonds, cryptocurrency, or any passive form of income. As a strategy, the owners might make that investment through the C corporation to lock in that 21% tax rate. Trouble comes if those investments start to turn a high profit, but the business owners are not distributing any of that money. When that passive income exceeds that 60% threshold, you may suddenly find yourself owing a personal holding company tax.
What’s the solution? Simple—make a distribution. The key here is to not let that moment sneak up on you, so ideally, you can make those distributions when tax is at its lowest.
C Corps Come With Their Perks
With considerable strategy and intentionality, you can still see tax savings with a C corporation. For instance, your stockpiled cash can be used to pay federal and state income tax or payroll tax. What’s more, state income tax payments can become an “ordinary business expense” deduction that lowers our federal taxes. If certain shareholders also work for the business, you may also be able to offer cash benefits to indirectly cover their individual tax payments. This lowers taxable income for the C corporation itself while also covering costs for the shareholders.
If you know the legitimate strategies for tax savings in a C corp, you can make that entity choice work for you. Trouble comes to those who look for sneaky ways to avoid tax altogether—and find that the IRS was already steps ahead of them.
You Don’t Need Tricks to Lower That Tax Bill
At the American Institute of Certified Tax Planners, we don’t need to rely on “hacks” and gimmicks to nab tax savings. When you know the actual tax rules, you are better prepared to avoid unnecessary penalties and to structure your income and expenses to give you the best advantages.
While C corporations are known for their tax challenges, some business owners will find that the pros outweigh the cons. If you can sidestep pitfalls like the personal holding company tax and maximize the benefits unique to C corporations, you might find that this is the best entity type for your tax plans. Turn to the experts when you need help navigating your business taxes—reach out to a Certified Tax Planner.
