For years, experts (myself included) often advised startups and small businesses to consider the Limited Liability Company (LLC). The alternative C Corporation possessed less flexibility, ease of administration and tax advantages. However, changes in the tax law from the 2017 Tax Cuts and Jobs Act now create a new potential for big tax savings. And they make the C Corporation a strong option for businesses of all sizes.
A full tax season has passed since the Tax Cuts and Job Act was enacted. So it’s time to take a new look at corporate structure. And to determine if the C Corporation structure is right for your business.
C Corporations, S Corporations, and LLCs – a brief overview
Let’s look at the new tax implications. Start with some of the basics of a C Corporation. Then continue with S Corporations and LLC.
A C Corporation exists as a type of company owned by shareholders. And an elected board of directors run it. But from a legal perspective, corporations are separate entities. And they can get sued and sue. Consider this important point. The corporation becomes responsible for legal and financial liability. And owners are often shielded from personal liability.
In addition, corporations become separate tax payers. And they pay taxes at a corporate tax rate. But this leads to the commonly known “double taxation” issue with C Corporations. The IRS taxes income first at the corporate tax rate. And then taxes come out at the individual tax rate when dividends are distributed to shareholders.
Individual tax rates were cut in the 1980s. And the C Corporation structure hasn’t made much sense for smaller businesses since. So savvy business owners often created pass-through entities like S Corporations and LLCs where business income passes through to the individual’s tax return. In fact, the C Corporation offered little advantage to smaller businesses who weren’t going public or looking for venture capital funding.
The two common pass-through entities are the S Corporation and LLC. An S Corporation is a C Corporation that has elected pass-through tax treatment with the IRS. Like the C Corporation, an S Corporation is owned by shareholders and run by a board of directors.
An LLC is a different kind of entity. As the name implies, it helps shield owners from personal liability with the business (like a corporation). But, an LLC is much less complex to run and manage. With the corporation, you need to appoint a board of directors, hold an annual shareholders’ meeting and directors’ meetings, document key shareholder and director decisions, and file a separate corporate income tax return. For an LLC, you typically just need to file an Annual Report with the state.
Tax Law Changes Make the C Corporation more Attractive
A major reduction in the C Corporation tax rate remains one of the big goals of the 2017 Tax Cuts and Jobs Act. It dropped from 35% to 21%. This lower corporate tax rate combines with additional benefits of IRC 1202 to make the C Corporation particularly attractive for some businesses.
Haven’t heard of IRC 1202? You’re probably not alone. It’s a generous capital gains tax exemption that was championed by President Obama. But it didn’t receive much attention until the corporate tax rate was lowered. In essence, if you qualify for IRC 1202, you might be able to exclude 100% of the gain up to $10 million or 10 times your original investment. You need to hold the stock for five years and there are many other requirements too. To learn more about IRC 1202 here, I recommend this post, as well as talking to your tax advisor.
With the lower corporate tax rate and IRC 1202, the C Corporation can now be extremely advantageous for the following scenario: you launch a business, expect to start smart small, make profits and plan to keep earnings within the company, and then cash out after holding the stock for five years or more.
What Business Structure is Right for Me?
Without factoring in all the specifics of your individual situation, it’s impossible for an article to provide a definitive answer on which business structure is right for you. With that said, there are a few things to consider…
Do you need to live off your business’ profits each year? If so, taking money out of the corporation will trigger dividend taxes – and therefore, business profits will essentially be taxed twice. If you are planning to put the business profits in your own pocket each year, a pass-through entity, like the S Corporation or LLC, might be better.
Are you planning on keeping your business “forever”? Keep in mind that capital gains taxes are erased at death, so if you’re never planning to sell your business, you may not need to bother with a C Corporation/IRC 1202.
Are you looking to keep things as simple as possible? As I mentioned before, running a C Corporation or S Corporation requires more regulations and paperwork than an LLC. If you form a C Corporation/S Corporation, be ready to spend more time keeping track of tax, business and financial records.
Do you plan on holding the business for at least five years and then sell? If so, the C Corporation could be very advantageous – particularly if you will be keeping profits within the business until cashing out.
Are you concerned about your personal liability? One of the key reasons to form an LLC or Corporation has always been the ability to minimize the personal liability and protect the personal assets of business owners from things that happen in the business. This holds true whether you form a C Corporation, S Corporation or LLC.
How to Incorporate
If you are interested in forming a C Corporation, it might be easier than you think. Follow these steps…
- Choose an available business name for your state
- Appoint the corporation’s directors
- Register the C Corporation with the state, and draft and file your Articles of Incorporation. You can do this yourself or have an online legal filing service handle it for you.
- Issue stock certificates to the initial shareholders
- Obtain the necessary local permits and business licenses
- Apply for an Employer Identification Number (EIN) with the IRS
If you have an existing business that’s currently structured as a pass-through S Corporation or LLC, you may decide it’s now more advantageous to operate as a C Corporation. If you’re an S Corporation, it’s an easy change to make. With majority shareholder consent, an S Corporation may revoke its S Corp election with the IRS (depending on timing, the revocation may retroactively apply for the whole tax year, or you may need to split the tax year between S Corp status and C Corp).
If you’re an LLC and want to restructure as a C Corporation, your state may allow a statutory conversion, which is a streamlined process. An alternative route is to create a C Corporation and then merge your LLC with the C Corp. This involves a bit more paperwork — but in some cases, the tax savings could be worth it.
The bottom line is your business structure doesn’t have to be set in stone. With the current changes to the tax law, this could be a good time to think about your business structure of a new or existing business.