Changes in the tax law drives
dozens of decisions- including decisions by business owners. I’m often asked
about the pros and cons of organizing a business as an S-Corporation vs. a
C-Corporation. The Wall Street Journal had a great article on the topic: “New
Tax Riddle: Pick S or C?”. I’ve included a link to the article below.
Why the issue has come up now:
Individual income tax rates
are increasing. The highest personal income tax bracket in 2013 is 39.6%, vs.
35% in 2012. As the article points out, “95% of all business entities declare
business profits on their owners’ personal tax returns, according to Congress’
Joint Committee on Taxation”. Higher personal tax rates may mean higher
taxes on business profits- if you pay tax via your personal return.
The current top tax rate for
corporations is 35%. To spur economic growth, Congress may lower that rate to
28%. By organizing as a C-Corp (explained below), an owner may pay a lower tax
rate. That’s because the top corporate tax rate (35%) is lower than the top
personal tax rate (39.6%). All this, of course, is subject to change.
S-Corporation vs. C-Corporation:
With an S-Corporation, the
profits “flow through” to the owners. Think of the S-Corp as a bucket with a
hole in the bottom. All of the profits and losses go into the bucket- but run
out the bottom. The profits and losses are taxed to each owner’s personal tax return-
at the personal income tax rates.
A C-Corporation has two
levels of taxation. In this case, the bucket (of profits and losses) does not
have a hole in the bottom. The C-Corp files a tax return and pays corporate
taxes- and corporate tax rates. If the C-Corp then pays a share of earnings to
owners, those dividends are taxed at the owner’s personal tax rate.
An example:
Assume a company has $1,000
in profits. Bob, the sole owner, has organized his company as an S-Corp. His
2013 personal income tax rate (federally) is 39.6%. Since the S-Corp profits
flow through to his personal return, Bob pays $396 through his personal tax
return.
If the company is a C-Corp,
Bob’s company files a corporate tax return and pays a 35% corporate tax rate.
In this example, Bob would pay $350. Considering just the corporate profits,
Bob lowers the tax rate by $46 ($396 vs. $350).
Although the tax paid is
lower, keep in mind that Bob has not paid out any company profits to himself.
Say the company pays Bob $50 in dividends. Those dividends will be taxed at the
top personal tax rate of 39.6%. Bob would incur another $19.80 in tax on his
personal return. The total tax on earnings using the C-Corp is ($350 corporate
return + $19.80 personal return = $369.80). If the dividend distribution is
only $50, the C-Corp method provides a lower total taxable amount ($369.80 vs.
$396).
The C-Corp concept may create
a lower total tax bill if the owner is able to leave profits in the company-
and not take them as a dividend. If the dividend was $150, Bob would incur a
$59.40 tax on the dividend. The total taxation would be ($350 corporate return
+ $59.40 personal return = $409.40). The $150 dividend would result in a higher
total tax amount, using a C-Corp.
In spite of the C-Corp’s double
taxation, choosing a C-Corp has other benefits. You may be able to issue
different classes of stock. Maybe one stock class has voting rights, and the
other doesn’t. A C-Corp may also allow you to issue an unlimited number of
shares. You may have more flexibility to raise capital with a C-Corp.
Wall Street Journal Article Link:
http://online.wsj.com/article/SB10001424127887323764804578314583989674920.html?KEYWORDS=New+Tax+Riddle%3A+Pick+S+or+C
Your comments are welcome! Visit my website for online classes on the toughest accounting topics.
Thanks!
Ken Boyd
St. Louis Test Preparation
(cell) (314) 913-6529
(you
tube channel) kenboydstl
(blog) http://accountingaccidentally.blogspot.com/
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@StLouisTestPrep
Author/ Cost Accounting for Dummies (John Wiley and Sons) March 2013
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