While most entrepreneurs set up their businesses as "pass-through entities" taxable on their personal returns, the traditional corporation retains fans. "C" corporations pay their own tax, unlike "S corporations," which "pass through" their income to their owners returns. Economist Martin Sullivan ponders why this old format still hangs on:
Graduated corporate rates, the low rate on corporate dividends, and an exemption from payroll taxes combine to make subchapter C the most advantageous choice for a lot of small business profits. If a business owner can afford to leave profits inside the corporation, the resulting deferral of individual tax only makes subchapter C more attractive.
While the top tax rate for individuals and corporations is 35%, C corporation rates are as low as 15% for the first $50,000 of taxable income. This can be attractive to a top bracket individual. Some tax-free fringe benefits are also available to owners only in C corporations.
In venture capital deals, sometimes C corporations are required because they are funded by tax-exempt entities. If business income passes through to tax-exempts, they may have to pay "Unrelated Business Income Tax." They prefer dividends and capital gains from C corporations, which they can receive tax-free.
Still, there are good reasons for the popularity of pass-throughs.
- The 15% bracket can only be used in one corporation with the same owners.
- "Personal service corporations," including law, medical, accounting and consulting practices, don't get the lower brackets.
- Appreciated assets inside a C corporation can be trapped there because a distribution is taxed to the corporation as a sale and to the recipient as a dividend at fair-market value. This can get very expensive when it comes time to sell.
You should consult with your tax professional when it's time to choose a tax structure for your business. You might also want to ponder these words from the standard treatise on corporation taxes:
Decisions to embrace the corporate form of organization should be carefully considered, since a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.
Though, a C corporation is still likely to have a better ending than the lobster.
Image by Hartmut Inerle via Wikipedia under Creative Commons Attribution-Share Alike 3.0 Unported license.