On December 22, 2017 President Trump signed the Tax Cuts and Jobs Act into law. The new law significantly changed the tax landscape in a number of important ways. As a result of tax reform, the federal corporate income tax rate is now 21%, down from as high as 35%. While this was designed to incent large corporations to bring their offshore money back to the United States, it applies to all business entities taxed as C Corporations, not just the “big boys”.
As a result, C Corporations are a lot more attractive than they used to be. But, they are not necessarily better than S Corporations or other “pass-through” entities such as Limited Liability Companies. This is because C Corporations still have double taxation.
While it is true that the C Corporation itself pays 21% at the federal level, the owners have to pay additional tax if they want to get the money out of the Corporation. Here’s how it works: let’s assume that XYZ Corporation, a C Corporation, earns $100,000 in profits. At the end of the year it has to pay $21,000 to the IRS for its federal tax bill. That leaves $79,000 left over. At this point, the Shareholders are feeling pretty happy. Their XYZ Corporation only paid 21% in taxes in comparison to the higher percentage they might have paid in the past. If the shareholders do not mind leaving the money in the XYZ Corporation, then all is well. But, if they want to actually take the money out for themselves, there will be more tax to pay.
Let’s assume that there’s only one shareholder, Debbie, and she is a full-time employee of XYZ Corporation. Debbie can legitimately take the $100,000 out of XYZ Corporation as salary for herself as long as this is reasonable compensation for her services. XYZ Corporation can deduct her salary from its taxable income, which could even zero out its federal income tax liability. But, Debbie will have to report this as ordinary income on her personal tax return. Her personal tax bracket could be higher than 21%.
But, what if Debbie takes some of the money out as a dividend? Dividends are not tax deductible by the XYZ Corporation. Assuming that XYZ Corporation had $100,000 in earnings, the Corporation will still need to pay the $21,000 in tax, leaving only $79,000 to distribute as a dividend.
And, the dividends are not tax free. Let’s assume that Debbie is married and has a total taxable income of $150,000, including the dividend. This would put her in the 15% tax bracket for dividends. Since the total dividend is $79,000 (remember, XYZ Corporation had to pay $21,000 in tax), the tax on the dividend would be $11,850.
The total tax burden ($21,000 at the corporate level plus $11,850 for the dividend) is $32,850, or 32.85% of the Corporation’s earnings. By contrast, if XYZ Corporation had elected to be taxed as an S Corporation, the total tax would have been substantially lower.
Obviously, this is only one example. In some situations, it can be beneficial for a Corporation to be taxed as a C Corporation. But businesses that need to make distributions will often find that an S Corporation or an LLC will be more tax efficient. It definitely makes sense to “run the numbers” with your tax advisor before making a final decision.
This is a general overview and not to be confused as legal advice. If you would like to speak to Jonathan about your legal, business or tax matter, please email him at email@example.com or call him at (925) 217-3255.