Robert L. Rojas, CPA, M.S. – Taxation, CExP,
Rojas & Associates, CPAs
Los Angeles, Newport Beach, Sacramento,
rojascpa.com
J. Michael Pusey, CPA, National Tax Director
Introduction
This article is to help entrepreneurs, owners and their advisers understand the tax implications which follow the choice of setting up your business operations.
We offer a detailed look at the C corporation. We cover ownership by the individual (the sole proprietorship), the S corporation, and the partnership.
A C corporation is simply one which hasn’t elected S corporation status for a particular year. It is possible for a corporation to have a history that includes C corporation status for some periods and S corporation status for other periods.
A single individual cannot be a partnership, although spouses can operate as a partnership. Thus it is possible for a single individual to operate a business as a C corporation or S corporation.
The limited liability company, the LLC, can be disregarded as an entity if owned by an individual. An LLC with multiple members is generally taxed as a partnership. It is also possible for an LLC to be taxed as a corporation.
Many of the details of how to achieve a particular tax entity result may be learned from IRS Form 8832 and its instructions. Please see attached link. https://www.irs.gov/pub/irs-prior/f8832–2002.pdf
Many factors go into choosing an entity structure. This is focusing on only the tax implications.
The prominent tax distinction in any entity discussion is entity level taxation with C corporation status versus the flow-through of income and deductions to the owner(s) in the case of the partnership and S corporation.
The C corporation’s tax rate is currently a flat 21%. The 2017 Tax Cuts and Jobs Act is known for reducing the corporate tax rate but it actually increased the corporate tax on lower levels of income. After 2017, our corporate tax rate is 21% for business corporations and personal service corporations. The 21% rate applies to business and investment income inside the C corporation.
While many of the provisions of the 2017 Tax Act were temporary, the change in the corporate tax rate was permanent, until the next legislative change. ((Conf. Rep. to accompany H.R. 1, 115th Cong., 1st Sess., Rep. 115-466, 12/15/17, p. 343-346.))
On the other hand, the reduction in the individual tax rate structure was not permanent. The somewhat higher individual rate structure in place before the 2017 Tax Act returns after 2025. ((Conf. Rep. to accompany H.R. 1, 115th Cong., 1st Sess., Rep. 115-466, 12/15/17, p. 200.))
We will discuss some of the math involved in comparisons of income subject to corporate tax rates versus individual rates, emphasizing generally that at higher income levels, the corporate rate structure can be advantageous.
We won’t present detailed math examples of the post-2025 corporate rate structure compared to the individual rate structure. Keep in mind generally that the corporate rate advantage at higher levels of income gets somewhat more pronounced after 2025.
C Corporations do not get a tax break on long-term capital gains as do individuals.
The 2017 Tax Act introduced a benefit for investing in economically disadvantaged areas called the qualified opportunity zone benefit, which is generally available to corporate and noncorporate taxpayers. As to investments after 2019, the benefit is largely a forgiveness of 10% of pre-investment gain rolled into such funds. Then the remaining pre-investment gain is triggered as of December 31, 2026. There can be an element of forgiveness of another 5% of pre-investment gain if the investment in the qualified opportunity fund occurred by the end of 2019. There may also be a benefit accorded gain on the qualified opportunity zone investment itself if it held over ten years. So while the benefit of the qualified opportunity zone emphasizes tax deferral, there may also be an element of gain forgiveness.
C Corporations generally get comparable access to the options of accelerating the deductions for capital expenditures under Section 168(k) and Section 179. ((See Gary Gunther, “The Section 179 and Section 168(k) Expensing Allowances: Current Law and Economic Effects,” Congressional Research Service, May 1, 2018; https://fas.org/sgp/crs/misc/RL31852.pdf.))
We generally forego discussions of unique rules pertaining to estates and trusts, other than to note that these entities may incur tax at the entity level or they may qualify to deduct distributions to beneficiaries. They may incur tax as entities or function as flow-through vehicles depending on the terms of the documents and the economics involved. Trusts and estates are not precluded from claiming the 20% of business income deduction. Trusts and estates with significant income are rather quickly taxed at the higher rates. In 2019, these are the tax rates on trust and estate income: 10% of first $2,600; 24% from $2,600 to $9,300; 35% from $9,300 to $12,750; and 37% of income over $12,750.
There are married filing separately rates and heads of households rates, but the great majority of individuals are currently taxed according to the following federal schedules in 2019 after the 2017 Tax Act. Our discussion emphasizes single taxpayers and married couples filing jointly.
Understanding Individual vs. Corporate Rates
Federal Individual Income Tax Rates for 2019
Single Individuals
| If taxable income is: | Then income tax equals: |
| Not over $9,700 | 10% of the taxable income |
| Over $9,700 but not over $39,475 | $970.00 plus 12% of the excess over $9,700 |
| Over $39,475 but not over $84,200 | $4543 plus 22% of the excess over $39,475 |
| Over $84,200 but not over $160,725 | $14,382.50 plus 24% of the excess over $84,200 |
| Over $160,725 but not over $204,100 | $32,748.50 plus 32% of the excess over $160,725 |
| Over $204,100 but not over $510,300 | $46,628.50 plus 35% of the excess over $204,100 |
| Over $510,300 | $153,798.50 plus 37% of the excess over $510,300 |
| Maximum incremental income in a bracket assuming $1,000,000 maximum in top bracket | Higher (lower) corporate rate times the bracket maximum |
| Not over $9,700 | Times + 11% = $1,067 |
| Next $29,775 | Times + 9% = $2,680 |
| Next $44,725 | Times – 1% = ($447) |
| Next $76,525 | Times – 3% = ($2,296) |
| Next $43,375 | Times – 11% = ($4,771) |
| Next $306,200 | Times – 14% =($42,868) |
| Next $489,700 | Times – 16% =($78,352) |
+
| Cumulative income at the end of the bracket maximum assuming $1,000,000 maximum in top bracket | Corporate tax is cumulatively more (or less) assuming the maximum cumulative income in a bracket |
| $ 9,700 | $ 1,067 |
| $ 39,475 | $ 3,747 |
| $ 84,200 | $ 3,300 |
| $ 160,725 | $ 1,004 |
| $ 204,100 | ($ 3,767) |
| $ 510,300 | ($ 46,635) |
| $1,000,000 | ($124,987) |
The first set of figures basically states the tax computation methodology. The second set of figures addresses the incremental income in a particular bracket. For example, the $29,775 is the difference in the maximums in the first and second brackets; within that level of income, the corporation is paying $2,680 more than would be paid by a single individual. The third set of figures shows the maximum cumulative income per bracket with a comparison of the corporate tax to the tax on a single individual. The last figure indicates the C corporation earning $1,000,000 pays $124,987 less tax than the individual.
Married Individuals Filing Joint Returns and Surviving Spouses
| If taxable income is: | Then income tax equals: |
| Not over $19,400 | 10% of the taxable income |
| Over $19,400 but not over $78,950 | $1,940 plus 12% of the excess over $19,400 |
| Over $78,950 but not over $168,400 | $9,086 plus 22% of the excess over $78,950 |
| Over $168,400 but not over $321,450 | $28,765 plus 24% of the excess over $168,400 |
| Over $321,450 but not over $408,200 | $65,497 plus 32% of the excess over $321,450 |
| Over $408,200 but not over $612,350 | $93,257 plus 35% of the excess over $408,200 |
| Over $612,350 | $164,709.50 plus 37% of the excess over $612,350 |
| Maximum incremental income in a bracket assuming $1,000,000 maximum in top bracket | Higher (lower) corporate rate times the bracket maximum |
| Not over $19,400 | Times + 11% = $2,134 |
| Next $59,550 | Times + 9% = $5,360 |
| Next $89,450 | Times – 1% = ($895) |
| Next $153,050 | Times – 3% = ($4,592) |
| Next $86,750 | Times -11% = ($9,543) |
| Next $204,150 | Times – 14% =($28,581) |
| Next $387,650 | Times – 16% = ($62,024) |
| Cumulative income at the end of the bracket maximum assuming $1,000,000 maximum in top bracket | Corporate tax is cumulatively more (or less) assuming the maximum cumulative income in a bracket |
| $ 19,400 | $ 2,134 |
| $ 78,950 | $ 7,494 |
| $ 168,400 | $ 6,599 |
| $ 321,450 | $ 2,007 |
| $ 408,200 | ($7,536) |
| $ 612,350 | ($ 36,117) |
| $ 1,000,000 | ($ 98,141) |
As with our single individual tables above, the first set of joint return figures just basically states the tax computation methodology. We note generally the joint return rates can be significantly less than the single rates. The second set of figures addresses the incremental income in a particular bracket. For example, the $59,950 is the difference in the maximum income levels in the first and second bracket, and within that level of income, the corporation is paying $5,360 more than would be paid by the married couple filing jointly. The third set of figures shows the maximum cumulative income per bracket with a comparison of the corporate tax to the tax on the couple filing jointly.
For example, we can see that the corporation with $1,000,000 in taxable income pays almost $125,000 less tax than the single individual and about $98,000 less tax than the married couple.
Our focus is planning, strategy, and what do we glean in terms of general planning principles from looking at our tables?
The most important perspective is our particular situation and our incremental tax brackets. The most important planning presentation is actually the second set of tables – the incremental taxes at different levels of income. Cumulative amounts are critical to our understanding but planning basically focuses on increments.
From an entity selection tax planning perspective, one generally wouldn’t want to shift income to a corporation with its 21% tax bracket, until one’s 1040 brackets exceeded such rate. Our focus is tax planning, not such significant factors as limited liability achieved via the corporate structure.
One of the important issues with a corporation is the double taxation effect on dividends of what remains of corporate earnings after it pays its taxes. This is an important consideration that will be noted but discussed in more detail later. We continue our emphasis on individual vs. corporate tax brackets.
Tax Bracket Perspective
We note the single individual and married individuals have the same series of rates that start at 10% and culminate in a top bracket of 37% but the ranges of income subject to the different brackets varies significantly.
For the Single Individual
One makes detailed calculations, but it may help from a perspective standpoint to do some rounding in our discussion.
We note the individual rates for singles are well below the corporate rates up to approximately $40,000. The corporate rate of 21% compares to 10% and 12% at approximately this level and below. So there is little or no incentive to shift income to a corporation at such levels.
The 21% corporate tax rate is not dramatically below the individual tax rates of 22% and 24%, although it is somewhat lower. The range of income here is roughly between the $40,000 to $160,000 range (rounding). But in general, it wouldn’t be worthwhile to shift income to a corporation to achieve such relatively minor rate differences.
Above the $160,000 level of income for the single individual, the rates begin to change rather dramatically. From $160,000 to a little over $200,000, the 32% rate reflects an incremental 8% from the previous bracket. The biggest rate jump isn’t at the top of the bracket schedule but more in the middle. Then from roughly $200,000 to $500,000 the rate goes up another 3%, then another 2% above the roughly $500,000 range, at which point the single individual is in the top individual bracket of 37% compared to the 21% corporate rate.
So particularly for the single individual, it isn’t necessarily the very high income taxpayer who needs to consider the advisability of shifting income to a corporation.
As we note below, our discussion is mitigated when we consider the degree to which non-corporate income would be subject to the 20% of business income deduction. As we will discuss in somewhat more detail below, not all business income qualifies for the 20% of business income deduction.
For the Married Couple
The rates for the married couple filing jointly are well below the corporate rates up to approximately $80,000, compared to $40,000 for the single taxpayer. The corporate rate of 21% compares to 10% and 12% at approximately this level and below. So, again, there is little or no incentive to shift income to a corporation at such levels.
The 21% corporate tax rate is not dramatically below the individual tax rates of 22% and 24%, although it is somewhat lower. The range of income here for the married couple is roughly between $80,000 to $320,000 (rounding). But in general, it wouldn’t be worthwhile to shift income to a corporation to achieve such relatively minor rate differences.
Above the $320,000 level of income for the married couple, the rates begin to change rather dramatically. From 320,000 to roughly $410,000, the 32% rate reflects an incremental 8% from the previous bracket. The biggest rate hike isn’t at as low a level as in the case of the single individual, but again, neither is it at the top of the bracket schedule but more in the middle. Then from roughly $410,000 to $610,000 the rate goes up another 3%, then another 2% above the roughly $610,000 range, at which point the married couple pays tax incrementally at the top individual bracket of 37% compared to the 21% corporate rate.
So for the married couple, it is a much higher income level to attain a significant rate advantage by incorporating and filing as a C corporation.
The Incremental Perspective
From a planning perspective, a key focus is incremental income and expense.
Personal exemptions are no longer with us from 2018-2025. They return after 2025 but currently the main “given” tax break is the individual’s standard deduction. The 2019 standard deduction for the single individual is $12,200 and $24,400 for the married couple. The 2020 comparable figures are $12,400 and $24,800. The standard deduction increased with the 2017 Tax Act such that fewer itemize and more are borderline itemizers. A possible strategy in the current environment is to plan on maximizing qualifying itemized deductions in a particular year so as to itemize then use the standard deduction in the following year (or vice versa).
As we noted in an earlier newsletter: “Not everything in the 2017 Tax Act makes it more difficult to itemize. An example is the Act repealed the rule that partially phased out itemized deductions at higher income levels. This rule is reinstated after the repeal period of 2018-2025.”
Corporations don’t get a standard deduction or personal exemption.
One wouldn’t want to shift so much income to a corporation that the individual’s standard deduction went unused.
In planning, one would generally want to understand what is given and what is incremental.
For example, assume the individual is single, has stable passive income that basically absorbs the standard deduction and has wages that translate into taxable income of $100,000. We will assume the taxpayer contemplates a business opportunity expected to earn another $100,000. How would one analyze the decision of whether to have the added $100,000 in one’s individual 1040 or have it shifted to a corporate return?
The single individual is currently in the 24% tax bracket of $84,200 to $160,725. Incremental income would bring the taxpayer into the next bracket for single individuals, taxing income of $160,725 to $204,100 at a 32% rate. The incremental income in an individual return would incur tax of 24% on 60,725 and 32% on the next $39,275, or $27,142 compared to $21,000 if the income were in a C corporation. There is some savings, some not insignificant savings, but there are also added expenses and some additional work involved in managing a corporation.
An aspect of the planning here may also involve timing incorporation so as to shift income, but not losses, including initial losses, into the corporate structure where deductibility may be more limited.
This is the type of analysis and weighing one would do, keeping in mind our key focus is: What difference does it make? What is the incremental savings, or detriment, in terms of tax if one operates a business as a C corporation?
The 20% of Business Income Deduction
The 2017 Tax Cuts and Jobs Act introduced a highly important benefit for some non-corporate taxpayers for 2018-2025.
The benefit isn’t available to C corporations, so the decision to incorporate and operate as a C corporation is a decision to forego this important, albeit temporary, benefit.
The provision is generally available to individuals as to their business income and their flow-through of business income from partnerships and S corporations.
It is possible that realty rental income will qualify. ((Rev. Proc. 2019-38.))
Certain service incomes don’t qualify. The list is long and there are exceptions, but nonqualifiers include generally medical and legal related service providers, accountants, performing artists, athletes, as well as those involved in brokerage, financial services, consulting and actuarial science. Yet there are ranges of income where such taxpayers may qualify. There are ranges wherein the business income may partially qualify. The eligibility for the benefit may be pared back for sparsity of wages and/or capital expenditures.
In “doing the math” here, we’ll assume all of the corporate income is qualified business income that would otherwise qualify for the 20% of business income deduction.
An important concept to remember here that there are seven brackets of income for individuals, each with its own rate. Rates are, of course, increasing.
The 20% of business income deduction will effectively save tax at the highest bracket or possibly the highest two brackets because it is an incremental deduction.
Single Individuals
| If taxable income is: | Then income tax equals: |
| Not over $9,700 | 10% of the taxable income |
| Over $9,700 but not over $39,475 | $970.00 plus 12% of the excess over $9,700 |
| Over $39,475 but not over $84,200 | $4543 plus 22% of the excess over $39,475 |
| Over $84,200 but not over $160,725 | $14,382.50 plus 24% of the excess over $84,200 |
| Over $160,725 but not over $204,100 | $32,748.50 plus 32% of the excess over $160,725 |
| Over $204,100 but not over $510,300 | $46,628.50 plus 35% of the excess over $204,100 |
| Over $510,300 | $153,798.50 plus 37% of the excess over $510,300 |
| Maximum incremental income in a bracket assuming $1,000,000 maximum in top bracket | Higher (lower) corporate rate times the bracket maximum |
| Not over $9,700 | Times + 11% = $1,067 |
| Next $29,775 | Times + 9% = $2,680 |
| Next $44,725 | Times – 1% = ($447) |
| Next $76,525 | Times – 3% = ($2,296) |
| Next $43,375 | Times -11% = ($4,771) |
| Next $306,200 | Times – 14% =($42,868) |
| Next $489,700 | Times – 16% =($78,352) |
| Cumulative income at the end of the bracket maximum assuming $1,000,000 maximum in top bracket | Corporate tax is cumulatively more (or less) assuming the maximum cumulative income in a bracket before the 20% factor |
| $ 9,700 | $ 1,067 |
| $ 39,475 | $ 3,747 |
| $ 84,200 | $ 3,300 |
| $ 160,725 | $ 1,004 |
| $ 204,100 | ($ 3,767) |
| $ 510,300 | ($ 46,635) |
| $1,000,000 | ($124,987) |
| Cumulative income at the end of the bracket maximum assuming $1,000,000 maximum in top bracket | The 20% factor; i.e., the incremental 20% of business income deduction X the top tax bracket |
| $ 9,700 | $ 1,940 X 10% = $194 |
| $ 39,475 | $ 7,895 X 12% = $947 |
| $ 84,200 | $ 16,840 X 22% = $3,705 |
| $ 160,725 | $ 32,145 X 24% = $7,715 |
| $ 204,100 | $ 40,820 X 32% = $13,062 |
| $ 510,300 | $ 102,060 X 35%= $35,721 |
| $1,000,000 | $200,000 X 37% = $74,000 |
| Cumulative income at the end of the bracket maximum assuming $1,000,000 maximum in top bracket | Corporate income tax is cumulatively more (or less) after factoring in the 20% of business income deduction |
| $ 9,700 | $ 1,261 |
| $ 39,475 | $ $4,694 |
| $ 84,200 | $ $7,005 |
| $ 160,725 | $ $8,719 |
| $ 204,100 | $ $9,295 |
| $ 510,300 | $ (10,914) |
| $1,000,000 | $ (50,987) |
Our math in the last display is proved:
1st bracket 3rd bracket 7th bracket
Corporate income $ 9,700 $84,200 $1,000,000
Corporate tax @ 21% 2,037 17,682 210,000
Individual income $9,700 $84,200 $1,000,000
20% of business deduction 1,940 16,840 200,000
Taxable income 7,760 67,360 800,000
Tax 776 10,677 260,987
Difference $1,261 $7,005 ($50,987)
It would be possible for the math to involve two tax brackets. Under our assumptions of income at the top of the bracket, the tax benefit from the incremental 20% of business income deduction stays within the highest bracket for the level of income.
Our math demonstrates that the higher tax rate on the single individual gives maximum benefit to the 20% of business income deduction. At our highest level of $1,000,000 in assumed income, there is still a detriment to not having the income taxed at the lower corporate rate. But the difference is mitigated by the benefit of the incremental 20% of business income deduction being at the highest tax bracket. Without the 20% of business income deduction, incorporation saves $124,987 but with the Section 199A deduction, incorporation savings drop by $74,000 to $50,987.
In the fifth bracket of income, incorporation saves $3,767 in income tax without the 20% of business income deduction. However, when the deduction is available under our assumption that it applies to all of the business income, incorporation actually increases the tax.
Married Individuals Filing Joint Returns and Surviving Spouses
| If taxable income is: | Then income tax equals: |
| Not over $19,400 | 10% of the taxable income |
| Over $19,400 but not over $78,950 | $1,940 plus 12% of the excess over $19,400 |
| Over $78,950 but not over $168,400 | $9,086 plus 22% of the excess over $78,950 |
| Over $168,400 but not over $321,450 | $28,765 plus 24% of the excess over $168,400 |
| Over $321,450 but not over $408,200 | $65,497 plus 32% of the excess over $321,450 |
| Over $408,200 but not over $612,350 | $93,257 plus 35% of the excess over $408,200 |
| Over $612,350 | $164,709.50 plus 37% of the excess over $612,350 |
| Maximum incremental income in a bracket assuming $1,000,000 maximum in top bracket | Higher (lower) corporate rate times the bracket maximum |
| Not over $19,400 | Times + 11% = $2,134 |
| Next $59,550 | Times + 9% = $5,360 |
| Next $89,450 | Times – 1% = ($895) |
| Next $153,050 | Times – 3% = ($4,592) |
| Next $86,750 | Times -11% = ($9,543) |
| Next $204,150 | Times – 14% =($28,581) |
| Next $387,650 | Times – 16% = ($62,024) |
| Cumulative income at the end of the bracket maximum assuming $1,000,000 maximum in top bracket | Corporate tax is cumulatively more (or less) assuming the maximum cumulative income in a bracket |
| $ 19,400 | $ 2,134 |
| $ 78,950 | $ 7,494 |
| $ 168,400 | $ 6,599 |
| $ 321,450 | $ 2,007 |
| $ 408,200 | ($7,536) |
| $ 612,350 | ($ 36,117) |
| $ 1,000,000 | ($ 98,141) |
| Cumulative income at the end of the bracket maximum assuming $1,000,000 maximum in top bracket | The 20% factor; i.e., the incremental 20% of business income deduction X the top tax bracket |
| $ 19,400 | $ 3,880 X 10% = $388 |
| $ 78,950 | $ 15,790 X 12% = $9,389 |
| $ 168,400 | $ 33,680 X 22% = $14,009 |
| $ 321,450 | $ 64,290 X 24% = $15,430 |
| $ 408,200 | $ 81,640 X 32% = $26,125 |
| $ 612,350 | $ 122,470 X 35%= $42,865 |
| $1,000,000 | $200,000 X 37% = $74,000 |
| Cumulative income at the end of the bracket maximum assuming $1,000,000 maximum in top bracket | Corporate income tax is cumulatively more (or less) after factoring in the 20% of business income deduction |
| $ 19,400 | $ 2,522 |
| $ 78,950 | $ 9,388 |
| $ 168,400 | $ 14,009 |
| $ 321,450 | $ $17,438 |
| $ 408,200 | $ $18,590 |
| $ 612,350 | $ 6,749 |
| $1,000,000 | $ (24,141) |
Our math in the last display is proved;
1st bracket 3rd bracket 7th bracket
Corporate income $19,400 $168,400 $1,000,000
Corporate tax @ 21% 4,074 35,364 210,000
Individual income $19,400 $168,400 $1,000,000
20% of business deduction 3,880 33,680 200,000
Taxable income 15,520 134,720 800,000
Tax 1,552 21,355 234,141
Difference $2,522 $14,009 ($24,141)
As above, our math demonstrates that the higher tax rate on the single individual gives maximum benefit to the 20% of business income deduction. At our highest level of $1,000,000 in assumed income, there is still a detriment to not having the income taxed at the lower corporate rate. But the difference is mitigated by the benefit of incremental 20% of business income deduction being at the highest tax bracket.
Tailor the calculation of the tax difference as a result of incorporating to the particular situation.
The math can be a bit surprising.
A Pause for Perspective
A relative tax perspective is important. While calculations are important, the landscape can get so complicated that one has to judge when to quantify and when to “just keep in mind.”
The following are important additional considerations that can impact the corporate versus individual tax scenario, or the C corporation versus flow-through entity taxation via S corporations and partnerships.
Double Taxation
Another issue we discuss in the immediately following section is the contingency of a second tax on corporate earnings; i.e., the infamous “double taxation” effect of operating as a C corporation.
We say “contingency” because there are some circumstances in which corporate income won’t incur a second tax. A corporation with no appreciated property might liquidate without significant corporate tax impact and the liquidation proceeds might be taxfree to the shareholder if the original owner passed, and the shares were then owned by family with stepped up basis under Section 1014. A liquidation is generally taxable to shareholders but that is usually not the case if the basis of the shares equals the fair market value of assets received in liquidation.
One major reason for not having the business building inside the C corporation is that the death of the shareholder generally steps up the basis in the stock, but it doesn’t step-up the basis of assets inside of the corporation.
Corporate Wages and Interest Expense
The double taxation of corporate income is basically done away with by deductible corporate expenses benefitting the shareholder; i.e., wages or interest on shareholder loans.
Wages can also raise questions of deductibility because deductibility of compensation turns on the payments being reasonable in relation to the services. ((See also Section 162(m) limiting the compensation deduction for a publicly held corporation to $1 million.))
IRS agents may challenge wage payments as being disguised dividends.
Wages to a low-bracket family members who actually render service to the corporation can be advantageous from a tax rate planning perspective.
Structuring closely-held corporations usually includes review of loans from the owner. Interest expense at the corporate level may help reduce “double taxation” by generating a deductible corporate interest expense. The repayments of loans are not income to the related-party lender assuming the IRS respects the loans as reasonable and substantive, rather than disguised equity. One needs to have in mind the IRS rules governing the reasonableness of interest (and other expenses) given the related-party nature of the loans. ((Sec. 482, Sec. 7872.))
The 2017 Tax Cuts and Jobs Act introduced some complex rules governing and limiting the deductibility of interest but these new rules are generally not a problem when gross receipts are $25 million or less. ((Sec. 163(j); Conference Report to Accompany H.R. 1, 115th Cong., 1st Sess., House Rep. No. 115-466, December 15, 2017, p. 66, 385-392.))
Employee-Benefit Programs
Owner-employees are not necessarily precluded from participating in tax-advantaged employee benefit programs, but those rules can introduce many complications. The myriad rules may also turn on the particular ownership structure.
These aspects can also be important in deciding the particular ownership structure and what employee benefits the entity will offer.
Part of the analysis of whether to incorporate can also look at such aspects as retirement plans that include the owner, whether the owner currently has such benefits, the owner’s age, cost of covering the work force, etc.
Work force retention can be particularly critical when the business is to be sold.
FICA Tax
Wages also generally incur FICA tax, so payroll taxes can be an aspect of incorporating.
IRS agents may also challenge dividends as compensation that triggers payroll taxes.
Whether the business owner has third-party wage income can affect the math here.
Self-employment taxes are usually an issue when the business is unincorporated.
Social Security Benefits
Increased wage income with increased FICA payments can also eventually increase one’s social security benefits. This is rarely calculated. As a practical matter, it is usually a “keep in mind” type of issue.
Deferred Expenses and Income
Due to the time value of money, the deferral of taxable income is usually advantageous because it delays the payment of income tax. By the same principle, the deferral of expenses is generally disadvantageous because it delays the tax savings arising from the deduction.
There are issues of future tax rates. The taxability of payments to the shareholder may be, for example, post-retirement when the shareholder’s tax bracket is less than prior years.
There are, of course, issues of legislative changes in tax rates and the treatment of particular income or deductions.
Losses Can Be a Problem
One generally needs to avoid net operating losses at the C corporate level because after the 2017 Tax Act, there is generally no carryback of net operating losses, which seems particularly unfair.
For example, a corporation earning $100,000 in one year and breaking even the next year except for paying the owner say $100,000 of compensation ends up with a $100,000 net operating loss carryover to year three. The corporation pays tax on $100,000 over two years despite breaking even over those two years. It has the benefit of a net operating loss carryover but that benefit is delayed (time value of money issue) and is even contingent on there being sufficient future income to offset the loss carryover. ((See “Net Operating Loss Carryback Repeal Isn’t Getting the Attention It Deserves,” Rojascpa.com, April 22, 2017.))
There are also tax rules limiting the ability of new buyers of the corporation benefitting from pre-purchase losses that are carrying forward. The availability of the net operating loss deduction to the corporation can change with the introduction of new owners. A detailed discussion of those rules is beyond our scope.
The incorporate or not-to-incorporate math analysis can become complicated rather quickly.
In general, one needs a model tailored to the factors most important to the circumstances.
We turn to a more detailed discussion of dividends which, while generally taxable, don’t usually incur quite as much tax as one might expect.
Factoring in the Tax on Dividends
In general, distributions from your C corporation will be taxed a second time. If the corporate entity is not paying an expense, such as salaries or rents, the mere distribution of monies to the owners incurs “double taxation.” Dividend income from large listed companies and your closely-held business are generally taxed in the same manner.
Ordinary dividends would incur tax as other income looking to our tax brackets above. However, most C corporation payouts can be planned to be “qualified dividends” eligible for taxation at capital gains rates.
Single Individuals
| If taxable income is: | Incremental income tax rate / qualified dividend rate |
| Not over $9,700 | 10% income tax rate / zero capital gains rate |
| Over $9,700 but not over $39,375 | 12% income tax rate / zero capital gains rate |
| Over $39,375 but not over $39,475 | 12% income tax rate / 15% capital gains rate |
| Over $39,475 but not over $84,200 | 22% income tax rate / 15% capital gains rate |
| Over $84,200 but not over $160,725 | 24% income tax rate / 15% capital gains rate |
| Over $160,725 but not over $204,100 | 32% income tax rate / 15% capital gains rate |
| Over $204,100 but not over 434,550 | 35% income tax rate / 15% capital gains rate |
| Over $434,550 but not over $510,300 | 35% income tax rate / 20% capital gains rate |
| Over $510,300 | 37% income tax rate / 20% capital gains rate |
There is the detriment of (potentially) a second tax on the same income as business income (net of the corporate tax) eventually gets distributed to the owner(s), if it ever gets distributed. However, that needs to be viewed in the perspective of reduced tax at higher levels of income, when the income is shifted to a corporation then distributed as a dividend. We noted above on a cumulative $1,000,000 income assumption and assuming no 20% of business income deduction forfeiture by incorporating that the corporate tax was almost $125,000 less.
Note that one of our simplifying assumptions was one shareholder or ownership of the stock by a couple filing jointly, rather than multiple shareholders in varying tax circumstances.
Married Individuals
| If taxable income is: | Incremental income tax rate / qualified dividend rate |
| Not over $19,400 | 10% income tax rate / zero capital gains rate |
| Over $19,400 but not over $78,750 | 12% income tax rate / zero capital gains rate |
| Over $78,750 but not over $78,950 | 12% income tax rate / 15% capital gains rate |
| Over $78,950 but not over $168,400 | 22% income tax rate / 15% capital gains rate |
| Over $168,400 but not over $321,450 | 24% income tax rate / 15% capital gains rate |
| Over $321,450 but not over $408,200 | 32% income tax rate / 15% capital gains rate |
| Over $408,200 but not over 461,700 | 35% income tax rate / 15% capital gains rate |
| Over $461,700 but not over $612,350 | 35% income tax rate / 20% capital gains rate |
| Over $612,350 | 37% income tax rate / 20% capital gains rate |
As noted above, there is the detriment of (potentially) a second tax on the same income as business income (net of the corporate tax) gets distributed to the owner(s). But we also noted in our earlier discussions that given the lower corporate rate relative to the higher end of the individual rates, on a cumulative $1,000,000 income assumption the corporate tax was about $98,000 less when within a corporation, assuming a married shareholder and no 20% of business income deduction.
The double-taxation aspects to the C corporation are mitigated by deductible corporate payments which are generally taxable to the shareholder-employee or shareholder-landlord. There may be an element of deferral here also; e.g., shifting income to the C corporation with salaries/rentals coming to the shareholder/landlord at a later time.
However, particularly with rentals, it is generally advisable to keep the corporate building at the individual-shareholder level with reasonable, deductible rental payments being made to the building owners.
Also Incorporate These Considerations in the Incorporation Analysis
General Tax Principles
Among the issues that arise with corporations is: Who earned the income?
For example, there is the “assignment of income” concept which basically says if you earned the income as an individual, it is taxable to you despite your saying pay the entity. Also, the corporate entity can’t just be formed and ignored, but rather needs to register when necessary, be the party on contracts with third parties, etc.
Personal expenses should generally be kept out of the corporation. If family expenses are paid out of the corporation, they should be reimbursed or considered wages to the owner for services to the corporation, if reasonable.
An on-going general issue with closely-held corporations is the level of compensation. In general, compensation should be treated as wages to the extent reasonable.
Services to the corporation should generally be supported with such details as time logs and notes of accomplishments. An on-going general issue with closely-held corporations is whether payments to the owner and related parties constitute reasonable payments for services to the corporation, which are generally deductible, as distinguished from dividends, which are not deductible in computing the corporation’s income tax. Other issues here include payroll taxes which apply to wages but not dividends.
Among the myriad cutbacks in itemized deductions in the 2017 Tax Act was denial of a home office deduction when related to employment, but this wouldn’t apply to a business home office unrelated to employment. ((See Tax Cuts and Jobs Act, Conference Report to Accompany H.R. 1, 115th Cong., 1st Sess., House Rep. No. 115-466, December 15, 2017, p. 273-276.))
In general, larger C corporations may be required to use the accrual method of accounting, although this generally isn’t a concern unless corporate gross receipts approach $25 million. ((See Conf. Rep. to accompany H.R. 1, 115th Cong., 1st Sess., Rep. 115-466, 12/15/17, p. 382-384.))
Gain on Sale of C Corporation Stock
The tax rules at times raise up potential benefits only when a corporation operates the business.
One of the incentives for C corporations is that it may be possible to exclude a large amount of long-term capital gain from income under the Section 1202 provisions. The requirements for qualification tend to be somewhat complex but generally it is possible to qualify to exempt up to $10 million of gain (or potentially even a larger amount) when original issue stock is held more than five years. The gain eligible for exclusion may also arise from redemption or liquidation. In general, the stock needs to be acquired as original issue. Immediately prior to and after issuance, the issuing corporation shouldn’t have assets of more than $50 million. Certain types of trades or businesses don’t qualify; e.g., practice of law, farming, oil and gas extraction, operating hotels. The business generally needs to be an active trade or business.
Another possible avenue to the exclusion of the gain on C corporation stock is the sale of the stock to an employee stock ownership plan (ESOP). However, S corporation status with the entity being owned by an ESOP is an alternative route that can eliminate tax on the operating income. See generally the authors’ article “Employee Stock Ownership Plans Can Eliminate Gains Tax or Tax on Business Income.”
The topic is generally beyond our scope but consider when going into a C corporation structure whether it is suited to a likely buyer, not that a likely buyer cannot also buy assets in lieu of corporate stock. Keep in mind here that a successful business likely creates “goodwill,” an intangible asset basically attaching to the success of the business. While one can plan to keep a building out of corporate solution, this isn’t the case with goodwill. Goodwill relates to the business, not the owners of the business, and a payment to the corporation for goodwill would not yield long-term capital gain.
State Income Tax
One potentially significant issue is the enhanced deductibility of state income taxes on a C corporation’s income tax return, Form 1120. The 2017 Tax Cuts and Jobs Act generally limits to $10,000 the itemized deduction for the sum of state income tax and residential property tax.
The C corporation can generally deduct the full state income tax burden.
Keep in mind too that one may need to distinguish the basic state tax on the business income from any incremental fees or taxes just because there is now an entity. For example, an LLC in California incurs California’s $800 annual fee even if the entity is owned by a single member and it is not taxed as a corporation. (See “Limited Liability Company Filing Information, FTB 3556, California Franchise Tax Board, https://www.ftb.ca.gov/forms/misc/3556.html; “Limited Liability Company, Business type,” California Franchise Tax Board, https://www.ftb.ca.gov/file/business/types/limited-liability-company/index.html.))
There may be incremental tax savings as a result of incorporating, as may be the case with the state income tax on corporate income. Also look for incremental expenses.
State and local jurisdictions set their own rules and the result may have no relation to the federal income tax rules.
Miscellaneous Deductions
While it significantly reduced the tax rates, particularly for C corporations, the 2017 Tax Cuts and Jobs Act also cut back many deductions. Miscellaneous itemized deductions that exceed 2% of adjusted gross income were generally repealed for the years 2018-2025.
For example, while it may be possible to allocate the tax professional’s fees between tax preparation and accounting and generally apportion the fees between an individual’s Schedule C business income and expense form and the nondeductible itemized deduction, such fees would appear to be fully deductible on the corporation’s income tax return, presuming the work is reasonable and relates to the corporation’s business.
The tax planner may well want to review the individual’s situation and estimate the extent to which an individual’s expenses, such as investment fees and expenses, would be nondeductible through 2025 when related to an individual’s affairs but deductible when related to a corporation’s affairs. ((See Conf. Rep. to accompany H.R. 1, 115th Cong., 1st Sess., Rep. 115-466, 12/15/17, p. 273-276.))
High Income Years
One of the problems with high income years is the 3.8% tax of Section 1411 imposed on individuals but not corporations. This tax applies to not all types of income but rather reaches net investment income, such as interest, dividends, capital gains, rent and royalty income.
The tax applies at somewhat higher levels of income – modified adjusted gross income (MAGI) of $200,000 for singles and heads of households, or $250,000 in joint returns, or $125,000 in a return of a married individual filing separately. Thus deductions can help minimize any impact of the 3.8% tax.
The 3.8% tax might also be minimized or avoided by spreading capital gains over a period of years by installment reporting or deferring some sales.
Investment Issues
The personal holding company tax can apply to C corporations with significant amounts of passive income. ((Sec. 542.)) The basic concept of this penalty tax is to thwart incorporated pocketbooks, using a corporation as vehicle to reduce the tax on dividends and interest. There are ownership and gross income tests, and relief as a result of paying dividends.
The passive activity loss rules and at-risk rules can apply to C corporations.
“The passive activity rules generally limit your losses from passive activities to your passive activity income. Generally, you are in a passive activity if you have a trade or business activity in which you do not materially participate during the tax year, or you have a rental activity.
The passive activity rules apply to personal service corporations and closely-held corporations other than S corporations.” ((IRS Pub. 542, Rev. Jan. 2019, Corporations, p. 16.))
Other Than C Corporation Structure
Partnerships
The nuances of the tax rules pertaining to a particular entity can at times have surprising, even harsh, effects. An example is the Supreme Court’s partnership decision in Basye, 410 U.S. 441 (1973).
From a tax standpoint, partnerships are often discussed in terms of whether for a particular purpose they are considered an “entity” or “aggregate” of the partners.
A partnership of physicians was providing services to a hospital group. A portion of the compensation to the partnership was essentially non-contingent when viewed from the perspective of the entity, but it was contingent from the perspective of the doctors who were required to pay tax on their distributive shares of the income under Section 702(b). The provision’s key language mandated (and still mandates) that the partner’s distributive share of income is to be determined “as if such item were realized directly from the source from which realized by the partnership…” The end result was partners were taxed on flow-through income they might never receive because while the total was non-contingent to the entity, it could be contingent as to the individual partner.
So entity choices can require planning for particular circumstances.
But in general, the partnership flow-through of income and deduction rules tend to work relatively fairly, while avoiding the corporate problem of “double taxation.”
There are myriad complex partnership rules governing partnership contributions and distributions, but in general it may be possible to make taxfree contributions to and taxfree distributions from the entity, assuming the partnership isn’t being used to disguise a swap of assets between the partners.
Events that may result in larger basis in the partnership interest, such as death of a partner, may also involve step-up within the partnership. ((See Sections 734, 743, 754.)
A “family limited partnership” operates under the partnership tax rules, and is often structured in a manner to vest management in the parents, who may end up with nominal equity, while the children end up with the bulk of value. Valuation discounts are one of the goals of such a structure. Such vehicles may not only centralize management in a senior family member but also shelter assets from creditor claims.
Among the factors in entity selection for a business can be an analysis of such factors as estate tax and management of the family’s affairs generally. The estate tax is still an important factor, although the 2019 exemption for a single person is generally $11,400,000 in 2019, $22,800,000 for a married couple. The exemption levels are scheduled to go down after 2025. See the authors’ article, “The Basics of Family Limited Partnerships and Why They Are Still Important.”
S Corporations
We cannot approach a detailed comparison of partnership vs. S corporation structure, all compared to the C corporation structure.
S corporations are flow-through entities that are generally vehicles that avoid double taxation, like partnerships. S corporations tend to provide much less flexibility in planning compared to partnerships.
C corporations may be eligible to convert to S corporations but there may be some on-going effects of having been a C corporation, particularly as to having a corporate tax on gains realized during the first five years into the S election. ((Section 1374.))
There are myriad complex corporate rules governing contributions to and distributions from the corporation, but in general it may be possible to make taxfree contributions to a “controlled corporation.” ((Section 351.)) Distributions from the S corporation are likely to trigger taxable gains to the entity, which in turn flow through the S entity to the shareholder.
The death of a shareholder or sale of a shareholder’s interest may translate into enhanced basis in the stock but without a step-up in the basis of assets at the S corporation level.
Concluding Thoughts
With the 2017 Tax Cuts and Jobs Act, corporations have a 21% flat tax rate compared to the 37% maximum progressive tax rate for individuals. However, at the smaller levels and even somewhat larger amounts of taxable income, the C corporation structure doesn’t have as much advantage as one might initially expect.
There are, of course, non-tax factors that go into the business structure decision.
In general, we’d suggest detailed projections that quantify federal and state tax rates, the 20% of business income deduction and such other factors as are significant to the reader.
The complexities of incorporating or structuring business ownership generally requires professional help that includes an analysis of important tax aspects.
We have discussed many factors which may be significant and in need of quantification in a particular situation
Also keep in mind for consideration if not quantification a list of other matters that are important to you and your situation, including significant contingencies.
This article appeared in the May 2020 issue of Practical Tax Strategies.
