What Is It?
A C corporation is a type of business entity. Though the corporation may have many owners, it is nonetheless a single entity in the eyes of the law. Corporations may raise money by selling ownership interests (referred to as stock or shares) to shareholders. If the C Corporation earns profits, it usually does one of two things. It distributes the profits to the shareholders in the form of a "dividend" or reinvests the profits in the business. A C corporation is the same corporate entity as an S corporation. However, the tax treatment is very different between the two.
When Can It Be Used?
A C corporation can be used in almost any case. Though not usually the choice of last resort, it may be useful in those circumstances when, because of some prerequisite, alternative entities could not be chosen.
Virtually Unlimited In the Number and Type of Shareholders
A C corporation is generally unlimited in the number and type of shareholders it may have — quite unlike an S corporation or even a professional corporation (PC), both of which are somewhat restricted in this regard. Generally, only members of certain eligible professions are allowed to form a professional corporation. S corporations are limited to 100 shareholders who must meet certain eligibility criteria, while a C corporation can have any number of shareholders of nearly any type.
Non-Compensation Fringe Benefits Are Generally Tax Free To Shareholder-Employees
Fringe benefits are generally tax free to the shareholders of a C corporation. Two percent shareholders in an S corporation, by comparison, must pay taxes on the fringe benefits received.
Tip: By offering numerous fringe benefits to shareholder-employees, the corporation can compensate shareholders in a manner that results in a tax deduction for the corporation and a tax-free distribution to the shareholder.
Caution: The Tax Cuts and Jobs Act eliminated the deductibility of certain fringe benefits to the employer, unless those benefits are provided on a taxable basis to the employee. Consult a tax advisor for specific details.
Owners Are Generally Not Personally Liable For Acts of Corporation
The shareholders of a C corporation are generally insulated from personal liability. Liability for corporate action is limited to the extent of the shareholders' investments in the corporation (what they paid for their shares). This attribute is referred to as limited liability.
Caution: The limited liability feature may be lost if, for example, the corporation acts in bad faith, fails to observe corporate formalities (e.g., organizational meetings), has its assets drained (e.g., unreasonably high salaries paid to shareholder-employees), is inadequately funded, or has its funds commingled with shareholders' funds. A corporation's loss of its limited liability feature is referred to as the piercing of the corporate veil.
Tip: Buy liability insurance to mitigate your potential loss if the corporate veil is pierced.
Management Is Centralized
A C corporation offers centralized management through its board of directors. Shareholders of a C corporation indirectly participate in management by electing the board of directors and by voting on certain corporate issues.
Interests Can Generally Be Transferred Without Restriction
Shares of stock of a C corporation can generally be freely bought and sold without consequence to the entity structure (referred to as the free transferability of interests). Contrast this to an S corporation, where, though the shares are also considered freely transferable, a sale of stock to an ineligible shareholder disqualifies the corporation for tax treatment as an S corporation. With a professional corporation, sales of shares are allowed only to members of the same profession.
Flexibility in Sharing Profits And Control
Unlike an S corporation, which can have only one class of stock, the C Corporation can issue different classes of stock. In so doing, the C Corporation can regulate who can exercise control over the corporation.
Example(s): If a C corporation needs to raise more money, but it does not wish to give up any more control over the corporation, it could issue stock with no voting rights. However, for potential owners to be interested in buying stock in a company that doesn't allow them to have a "voice," the corporation might have to sweeten the deal by, perhaps, giving these investors the right to receive dividends before any other shareholder receives them. The C Corporation can do this by issuing a separate class of stock. While an S corporation can issue both voting and nonvoting stock, all outstanding shares of stock of an S corporation must receive an equal right to distribution of dividends and proceeds from asset liquidation.
Life of Entity Continues Indefinitely
A C corporation can "live" forever. This is referred to as continuity of life. It continues after the death, bankruptcy, retirement, insanity, expulsion, or resignation of an owner. Thus, your business will go on even if you don't.
Profits Are Subject To Double Taxation
Unlike an S corporation (a flow-through entity), the C corporation is subject to double taxation. The profits are taxable first at the corporate level when earned. They are subject to taxation again at the individual level when and if they are distributed to the shareholders as dividends.
Note: Double taxation may be less of a tradeoff in 2018 and beyond, thanks to the Tax Cuts and Jobs Act of 2017, which reduced the business income tax rate that C corporations pay to a flat 21% (from a high of 35%).
Entity May Be Relatively Difficult and Expensive To Form and Maintain
The C corporation may be the most difficult and expensive entity to form and maintain. To begin with, you must file documents with the state (e.g., articles of incorporation), adopt rules for self-government (by-laws), elect corporate managers (board of directors), and hold your first of many organizational meetings.
Entity Is Heavily Regulated
The C Corporation is subject to strict regulation by both local and federal governments. For example, the Securities and Exchange Commission, a federal agency, regulates the offer and sale of, among other things, a corporation's stock. However, federal registration does not apply to private offerings to a limited number of investors, offerings of a limited size, and intrastate offerings.
Therefore, such federal securities regulations do not apply to many private small businesses.
Shareholders Cannot Deduct Losses
Unlike those of pass-through entities, shareholders of a C corporation cannot deduct (subtract from taxable income) the corporation's losses from their personal income. Instead, the losses of the corporation are "trapped" at the entity level and can be taken only by the corporation at some time when it has income.
Tip: Generally, losses can be deducted by a corporation from income earned in any subsequent year (a "carryover"). Certain farming losses may be applied, or "carried back," to an earlier tax year. Due to the Tax Act passed in 2017, new limits apply to the amount of income that can be offset with losses.
Shareholders Can Be Taxed on Contribution of Appreciated Property
If a shareholder contributes appreciated property to the corporation, he or she will be taxed unless all of the shareholders' contributing property control 80% or more of the stock after contribution. Contrast this to a partner in a partnership or a member in a limited liability company (LLC), who is generally not taxed on such a contribution regardless of control. However, there may be later consequences for a partner or an LLC member who contributes appreciated property, including possible recognition of gain.
Liquidation of The Corporation Is A Taxable Event
When the corporation is liquidated (distributes all of its assets to shareholders), it is treated (and taxed) as if it sold the assets to the shareholders at fair market value (FMV). As a result, both the corporate entity and the individual shareholders may face tax consequences. A partnership or LLC, on the other hand, can generally liquidate with one level of taxation. However, a partner or LLC member may recognize gain or loss to the extent money is distributed to the partner or member in liquidation of the partnership or LLC.
How to Do It*
Consult an Attorney
You should consult an attorney experienced in business planning. The attorney should know the laws in your state (or your state of incorporation) that prescribe the requirements you'll need to fulfill.
Deliver Articles of Incorporation to Secretary of State
Generally, to create a C corporation, you must file articles of incorporation with your state. State law will dictate what you will need to include in this document. You must also adopt by-laws, elect a board of directors, and hold your first organizational meeting.
Your Corporation Is Automatically a C Corporation
The decision to be a C corporation is one of default. In other words, your corporation is automatically a C corporation unless approval is granted from the IRS for taxation under a different provision, such as an S corporation election. *Checklist is not exhaustive
Profits of the C Corporation Are Taxed Twice
As mentioned in the "Tradeoffs" section above, the profits of a C corporation are subject to double taxation: once when earned by the corporation, and again when distributed to the shareholders in the form of a dividend.
Example(s): As an oversimplified example, assume that shareholder A is in the 35% individual tax bracket and is the sole shareholder of XYZ Corporation. XYZ is a C corporation in the 21% corporate tax bracket. As a C corporation (not a pass-through entity) with $100,000 in profits and assuming no deductions, XYZ's corporate tax would be $21,000 (21% of $100,000). The remaining $79,000, if distributed to shareholder A as a dividend, will be taxed again at 15%: 0.15 x $79,000 = $11,850 in taxes. When combined, the tax rate for the corporation and the shareholder would equal 32.85% for a total of $32,850 in taxes.
Example(s): Assume instead that XYZ is an S corporation (a pass-through entity), the shareholder has $100,000 of qualified business income from XYZ, and the shareholder is able to claim a 20% deduction for the income. After claiming a $20,000 deduction, taxable business income from XYZ is reduced to $80,000. Shareholder A would pay $28,000 (35% of $80,000) in income tax. Total taxes paid on the $100,000 would be $4,850 less than it would in the scenario above.
Tip: By paying salaries or providing fringe benefits to shareholder-employees, or by paying rent or lending money to shareholders, you can mitigate the effects of double taxation. The double taxation may even be postponed by retaining profits for future corporate uses.
Caution: However, if profits are retained in excess of certain limits, the corporation may incur the accumulated earnings tax (AET) — A penalty tax. Generally, the IRS permits the retention of up to $250,000 without penalty. A corporation can retain more than this amount if there is a reasonable business purpose for doing so (e.g., diversification or expansion).
Dividends: Taxable to Shareholder, Nondeductible By Corporation
When the corporation distributes profits to shareholders in the form of dividends, the shareholders are taxed on the distribution. In addition, these payments may not be deducted by the corporation (unlike some fringe benefits and interest, rent, or wage payments).
Tip: The double tax may be avoided if the corporation, instead of issuing dividends, distributes income to shareholders in the form of salary, some fringe benefits for services rendered, payments of rent, or interest on loans from shareholders.
Caution: However, if these alternate forms of compensation are deemed unreasonably high, the IRS may classify them as dividends "in disguise" and tax them as such.
Note: As a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.
Fringe Benefits: Tax Free To Shareholder-Employees, Deductible by Corporation
Som fringe benefits (e.g., health insurance, tuition reimbursement) are generally tax free to the shareholder-employees of a C corporation. In addition, the C Corporation can deduct from its taxable income the fringe benefits provided. Two percent shareholders in an S corporation, however, are taxed on the fringe benefits received.
Tip: The Corporation may avoid some of the double taxation if it provides numerous fringe benefits to shareholder-employees. Fringe benefits are deducted from income. This leaves less (taxable) profit for distribution to shareholders.
Wages: Taxable to Shareholder-Employees, Deductible by Corporation
A shareholder may be employed by the corporation, in which case the shareholder-employee is taxed on his or her compensation (wages). The corporation can deduct the wages paid to the shareholder.
Tip: Similar to fringe benefits, wages are not subject to double taxation. Moreover, if the corporation is taxed at a higher rate than the shareholder-employee, then he or she may save in taxes.
Caution: If the wages paid to a shareholder-employee are unreasonably high, the IRS will likely recharacterize the wages as dividends and disallow the corporation from taking a deduction for wages paid.
Rent: Taxable to Shareholder, Deductible to Corporation
A shareholder can rent personally owned property to the corporation. The corporation can deduct the rental expense and the shareholder is taxed on the rent received.
Caution: If rent payments are considered unreasonably high, the IRS may classify them as dividends and tax them as such.
Shareholder Loans to Corporation: Interest Payments Deductible by Corporation
Shareholders can loan money to the corporation. The primary advantage of the issuance of debt is the avoidance of the double taxation. The corporation deducts from its taxable income the interest payments made on the loan (something it can't do with dividends). The shareholder, however, pays tax on the interest payments received but will get the loan principal back without tax ramifications.
Caution: The loan must be well documented or it will be classified as a dividend in disguise and taxed as such.
Losses: Cannot Be Deducted By Shareholders
Losses of a C corporation, unlike the losses of an S corporation, are not deductible by shareholders on their personal tax return. Generally, losses can be deducted by a C corporation from income earned in any subsequent year. Certain farming losses may be applied, or "carried back," to an earlier tax year. Due to the Tax Act passed in 2017, new limits apply to the amount of income that can be offset with losses.
The Accumulated Earnings Tax (AET)
The AET is imposed when a C corporation, rather than distributing profits to shareholders as dividends, retains them in excess of certain limits. The IRS generally permits retention of up to $250,000 — more if for a valid business purpose (e.g., expansion or diversification). The AET is typically not imposed upon S corporations.
Caution: To avoid the AET, the corporation's board of directors must discuss (in meetings) and document (in minutes) the need to retain profits. Also, the corporation should set up an appropriate retained earnings account, so that the corporation has a method by which shareholders are regularly informed as to how much of its earnings will be retained.
Questions & Answers
What Happens When an Owner of a C Corporation Dies?
When a C corporation owner dies, the business entity itself can continue indefinitely. Assuming no stockholder agreement prohibiting transfer, the ownership of the shares generally passes through the shareholder's estate with no effect on the continued existence of the corporate entity. The life of the corporate entity is separate from that of any of the owners and can continue for many generations. It is one important reason why this form of entity is chosen.
Can You Change From One Type of Entity To a C Corporation?
You can change from one type of business entity to another. Often, a business may begin as a sole proprietorship and become a C Corporation sometime later. You can also convert from a C corporation to another type of entity. Bear in mind, there may be tax consequences to any entity conversion.
What Does It Mean That C Corporation Interests Are "Freely Transferable"?
Many times, the shares of a C corporation are traded on a stock exchange, such as the New York Stock Exchange, or even one of the regional exchanges. You could call your broker and buy or sell shares as you choose. Of course, it may not be as easy as that. Some publicly traded companies may not have a very active market, and many C corporations are not traded on a public exchange, but theoretically, there are no restrictions on the sale of your stock. You could sell to one person, 20 people, or even another corporation. This is very different from an S corporation, which is limited to 100 shareholders, all of whom must meet certain restrictions, and some types of professional corporations that are limited to individuals within specific professions.
As An Owner of a C Corporation, Could You Lose Your Personal Assets As A Result of an Action of The Corporation?
Generally, the personal assets of owners of a C corporation are insulated from corporate liability. For instance, if the C Corporation is sued by an individual or another business, your personal assets such as your home or your automobile are not exposed as a result of the lawsuit against the company. Your risk is limited to the value of your investment in the company. This is completely different from a sole proprietorship, where the business and the owner are indistinguishable, and the owner could lose all business and personal assets as a result of a business activity. This limited liability is one very important reason why many businesses initially established as a sole proprietorship eventually become incorporated. It is important to note, however, that this limited liability may be lost if, among other things, the corporation acts in bad faith, fails to observe corporate formalities, has its assets drained, is not adequately funded, or has its funds commingled with those of shareholders.
This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.
The Retirement Group is not affiliated with nor endorsed by fidelity.com, netbenefits.fidelity.com, hewitt.com, resources.hewitt.com, access.att.com, ING Retirement, AT&T, Qwest, Chevron, Hughes, Northrop Grumman, Raytheon, ExxonMobil, Glaxosmithkline, Merck, Pfizer, Verizon, Bank of America, Alcatel-Lucent or by your employer. We are an independent financial advisory group that focuses on transition planning and lump sum distribution. Please call our office at 800-900-5867 if you have additional questions or need help in the retirement planning process.
The Retirement Group is a Registered Investment Advisor not affiliated with FSC Securities and may be reached at www.theretirementgroup.com.