C-Corps versus S-Corps versus LLC’s
The Key Differences and Where a C-Corp Fits
There are many differences, oft times complex ones, between C-Corps, S-Corps, and LLC’s. To know definitively which is best for you requires a more in-depth look and consideration of more than will be detailed here. Our goal here is to understand the major differences, and if a C-Corp tax strategy might work for you.
S-Corps and LLC’s are known as pass-through entities. ‘Pass-through’ is an apt name as these entities do not pay corporate income taxes, instead passing their net income on to the shareholders’/partners’ personal tax returns to be taxed at each’s personal income tax rate. The income passed-through the S-corp is not subject to self-employment tax, only income tax. Income passed through an LLC is generally subject to both.
C-Corps pay corporate income taxes and they retain their earnings. For an owner to receive profits from a C-Corp they must take it as either a salary or a dividend which creates double-taxation: the C-Corp first pays corporate income taxes and then the owner pays individual income taxes or capital gains taxes, plus sometimes FICA on the profits they receive.
Immediately, most business owners will flag C-Corps as non-beneficial entities due to the double taxation, and usually they are correct. Double taxation should be avoided at all costs, which is why we only use C-Corps as part of advanced tax mitigation strategies and in conjunction with other entities, particularly S-Corps.
The time to consider a C-Corp as part of your tax mitigation strategy is when your personal income breaches the 32% bracket. Any individual income reaching this bracket is hit with a combined federal and Alabama rate of 37%. With the combined federal and Alabama corporate tax rate being 27.5%, would it not be nice to replace our 37% rate with a 9.5% lower one?
Imagine we have $50,000 being hit with 37%. If we could somehow shift that into a C-Corp we would save nearly $5,000 in taxes. The problem then becomes ‘how do we access it?’ If your current S-Corp paid your newly created C-Corp for services, therefore creating a deduction under the S-Corp and revenue under the C-Corp (taxed at the lower rate), how do we then get our hands on that money without it being taxed again as a dividend or a salary?
C-Corps have several tricks up their sleeves. Let us say, for example, we establish a C-Corp to provide ‘administrative services’ to our other businesses. In year one we send $50,000 to our C-Corp saving $5,000. We retain these earnings and in year two send another $50,000, saving another $5,000. Now in year three we are ready to access some portion of this $100,000. We would not want to pull it out as income or we are taxed twice, so we spend it on legitimate needs of our S-Corp as ‘administrative support’. Need a new vehicle? Buy it under the C-Corp and lease it to the S-Corp. Need new computers? A new assistant? We access our retained earnings for legitimate business purposes to support our other enterprise. This creates a loss in year three, a loss that the C-Corp can carry backward to claim a refund against taxes paid in year two and one.
This is just one basic example of how to shift income into a C-Corp and later access it. The truth of C-Corps is much more complex. C-Corps allow for accountable plans, rental property purchases, loaning funds to other businesses and individuals, qualified dividends, and other excellent ways to access your retained earnings. They key to this is not having to ever just go ‘grab’ any of your funds funneled through you C-Corp. Taking them out through improper methods results in double taxation and defeats any benefit of a C-Corp being part of your portfolio.
There always needs to be a way to exit a C-Corp when the time comes. For example, a C-Corp that has been used to acquire rental properties has a few options. One way to exit such a C-Corp is to use a Charitable Remainder Trust. By transferring the property into a Charitable Remainder Trust, the C-Corp will not report a sale of the property. Instead, the Charitable Remainder Trust will sell the property and retain all of the cash from the sale. The Trust does not report capital gains and subsequently enjoys maintaining the entire principal balance of the real estate asset that was just sold.
This is a huge planning opportunity. By transferring to a Charitable Remainder Trust, the proceeds from the eventual sale of the property are not taxed at the Trust level, meaning you get to reinvest the full principal balance and watch your net worth grow exponentially. There are caveats, such as declaring a charitable organization and taking minimum distributions that you must then pay taxes on, but avoiding an initial massive tax bill is huge from a wealth planning perspective.
Bottom line, with the right planning, high income earners can execute a C-Corp strategy that saves at minimum 9.5% in taxes on a portion of their income.
Executing a C-Corp Tax Mitigation Strategy
Unfortunately, C-Corp strategies are complex and require a lot of attention. Accountable plans, for example, allow a C-Corp to reimburse you, tax free, for a number of expenses like medical and a home office, but they require paperwork and organization on a monthly basis. C-Corps do not work like converting to an S-Corp to avoid self-employment tax through which you make your S-election and you are done until tax time; C-Corps need tending and tending them wrongly can quickly negate the savings you are seeking.
Consequently, you need a tax professional managing your C-Corp. Depending on the scope of the strategy being implemented, these fees may range from $75 monthly to $1,000 or more, but for most business owners it is around $150.
With the increased accounting fees and effort involved you need to make sure it is worth it, typically you need to realize at least $5,000 to $10,000 or more in tax savings. How much you can expect to save is based on how much you intend to funnel through your C-Corp and what tax bracket you are escaping. If these factors produce a sufficient tax savings to justify the costs, and an exit strategy is kept in mind, a C-Corp may just have a place in your ever-expanding portfolio.