The common perception is that C corporations are the worst option when it comes to keeping taxes low. The most-cited reason? Double taxation. C corporation income is first taxed at the entity level at a 21% flat rate. The second hit comes when those dividends are distributed to the shareholders—this time at personal income tax rates. That seems to settle the matter. After all, who would willingly sign up to pay double the tax?
This is where experienced tax planners can chime in with a word of wisdom. While C corporations can easily become a tax-heavy option, this entity type also comes with unique tax benefits that can sometimes outweigh the negatives. Case in point: qualified small business stock. To make the best use of the benefits, the key is to be proactive. When we work with clients on advance tax planning, tax savings are possible, no matter their business’ entity type.
Proactive Planning for C Corps
When we’re working with a C corporation, how can we maximize tax savings and offset that double taxation trap? Start by looking at the six basic tax levers: income shifting, deductions, loopholes, rates, investment strategies, and tax credits. Then ask: which tax levers can have the biggest impact for a C corporation? By understanding how these work within a C corp specifically, we gain a clearer picture of the best strategies to apply.
C Corp Tax Strategies That Work
With enough advance planning, these tax strategies can make a C corporation work for business owners who are able to maximize them:
- Income recharacterization. A C corporation can function as an income recharacterization tool. Within a C corp, the owners have a certain amount of control over whether dividends are taxed at ordinary income tax rates or capital gains rates—mostly based on how long they hold onto the stock. This same benefit is not available with pass-through entities like S corps and partnerships.
- Special loopholes. By “loopholes,” we mean incentives created by the IRS for certain types of businesses, often by giving them a unique tax exemption. Take, for instance, the qualified small business stock (QSBS) loophole, which is only available to small C corporations. Though QSBS does not directly lower the company’s taxes, it can certainly draw in investors by offering a 100% federal capital gains tax exclusion on the sale of QSBS.
- The 21% corporate tax only. In some cases, business owners would be paying the highest personal income tax (37%) on all their distributions if they operated an S corporation or partnership. By comparison, the flat 21% tax on C corporations can be an appealing benefit, especially if you can apply other strategies to lower their taxable income. Of course, this is only true while that income stays in the business—but it can give you time to prepare for that second layer of tax when the distributions are made.
C Corp Limitations
Every upside has its downside, and so it goes with C corporations. Make sure you have factored in the limitations before recommending a tax plan. For instance, if you are planning to leverage QSBS benefits, do you know when the business originally issued that stock? If the stock was acquired before August 10, 1993, the QSBS provision had not officially been enacted yet—so sadly, that stock would not qualify for the benefit. On the other hand, stock issued between that date and September 27, 2010 is only eligible for a 50% tax exclusion. Only after September 27, 2010 did the 100% exclusion become available.
Limitations even come into play with the 21% corporate tax rate. Congress has anti-deferral rules in place to prevent taxpayers from parking passive income inside their C corporations. Though these rules mainly apply to passive income and investments in overseas companies, you need to be familiar with them to determine whether your client could owe unexpected taxes.
A C Corporation Does Not Have to Be an Obstacle
At the American Institute of Certified Tax Planners, we avoid assumptions about which entity types are “best” without getting to know our clients. Instead, we do the detailed analysis needed to actually see what the numbers say. If a new client already has a C corporation set up, the real question is: where are the tax savings opportunities for this particular client? And do the reasons they selected a C corporation still make sense given their current goals and financial situation?
Learn how to navigate the limitations and opportunities of each entity type like a pro—sign up to become a Certified Tax Planner.
