Forming a “C Corp” is a good strategy for many businesses, and it is the only type of corporation configuration appropriate for any company that intends to be publicly traded. It allows an unlimited number of most investors (foreign shareholders as well as US citizens) and offers significant liability protection.
One potential drawback, however, is double taxation. The FMS team of advisors can help you make the right decision to avoid tax or compliance challenges to your company’s operations.
Unlike partnerships, entities taxed as C corporations are separate taxpaying entities. Corporate income and loss is taxable, or deductible, only at the corporate level and is not passed through to the corporate shareholders. Although shareholders are not taxed on corporate income, they are taxable on corporate distributions. Thus, “dividends” (distributions out of the corporation’s current or accumulated earnings and profits) are taxable to shareholders at ordinary income tax rates and do not affect the shareholders’ bases in their shares.
Inherent in this statutory pattern is a well-known phenomenon commonly referred to as double taxation of corporate earnings. Double taxation is particularly obvious in connection with current distributions of corporate earnings: Such earnings are fully taxed to the corporation, when earned, without reduction for any amounts distributed to shareholders; they are again taxed to the shareholders, when distributed, as ordinary income dividends. If earnings are not distributed as dividends, the absence of a basis increase at the shareholder level generally results in a second tax when the corporation is liquidated or a shareholder sells his shares, since the amount realized, and hence the shareholder’s gain, will ordinarily reflect the value of undistributed corporate earnings that have already been taxed at the corporate level. Moreover, if a corporation distributes appreciated property as a dividend, in redemption of its stock, or in liquidation, the corporation must recognize the appreciation as taxable gain.
One potential drawback, however, is double taxation. The FMS team of advisors can help you make the right decision to avoid tax or compliance challenges to your company’s operations.
Unlike partnerships, entities taxed as C corporations are separate taxpaying entities. Corporate income and loss is taxable, or deductible, only at the corporate level and is not passed through to the corporate shareholders. Although shareholders are not taxed on corporate income, they are taxable on corporate distributions. Thus, “dividends” (distributions out of the corporation’s current or accumulated earnings and profits) are taxable to shareholders at ordinary income tax rates and do not affect the shareholders’ bases in their shares.
Inherent in this statutory pattern is a well-known phenomenon commonly referred to as double taxation of corporate earnings. Double taxation is particularly obvious in connection with current distributions of corporate earnings: Such earnings are fully taxed to the corporation, when earned, without reduction for any amounts distributed to shareholders; they are again taxed to the shareholders, when distributed, as ordinary income dividends. If earnings are not distributed as dividends, the absence of a basis increase at the shareholder level generally results in a second tax when the corporation is liquidated or a shareholder sells his shares, since the amount realized, and hence the shareholder’s gain, will ordinarily reflect the value of undistributed corporate earnings that have already been taxed at the corporate level. Moreover, if a corporation distributes appreciated property as a dividend, in redemption of its stock, or in liquidation, the corporation must recognize the appreciation as taxable gain.
The shareholder-level tax on corporate earnings and appreciation may be deferred, of course, if the earnings are not distributed and the shareholder does not sell his stock. Indeed, the shareholder-level tax on undistributed corporate income may be partially or completely avoided if a shareholder dies holding his stock, since at death, for purposes of computing gain, his shares pass to his estate at a basis equal to their fair market value on the date of death or alternate valuation date.
To forestall tax-motivated accumulations of corporate earnings, the Code contains two penalty taxes designed to encourage current payment of dividends: the “accumulated earnings tax” on corporations that retain income in excess of amounts reasonably required to meet their business needs and the “personal holding company tax” on corporations that are controlled by a limited number of individuals and that retain income derived primarily from passive sources (e.g., rents, dividends, and royalties) or from the performance of services by designated shareholders.
Rather than retain corporate earnings and run the risk of incurring the accumulated earnings or personal holding company tax, many closely held corporations attempt to avoid the double tax by distributing virtually all of their income to shareholders as deductible payments, usually as salaries and bonuses. If done carefully–with advice by competent tax guidance -this tactic avoids corporate tax entirely. However, compensation payments are deductible by the corporation only if the compensated shareholder actually renders services to the corporation and the amount of the compensation is reasonable. Compensation payments that exceed a reasonable amount are not deductible by the payor corporation. In addition, corporate earnings that are paid out in the form of interest on corporate debt to shareholders or rents for the use of shareholder-owned property may be deductible by the corporation.
To forestall tax-motivated accumulations of corporate earnings, the Code contains two penalty taxes designed to encourage current payment of dividends: the “accumulated earnings tax” on corporations that retain income in excess of amounts reasonably required to meet their business needs and the “personal holding company tax” on corporations that are controlled by a limited number of individuals and that retain income derived primarily from passive sources (e.g., rents, dividends, and royalties) or from the performance of services by designated shareholders.
Rather than retain corporate earnings and run the risk of incurring the accumulated earnings or personal holding company tax, many closely held corporations attempt to avoid the double tax by distributing virtually all of their income to shareholders as deductible payments, usually as salaries and bonuses. If done carefully–with advice by competent tax guidance -this tactic avoids corporate tax entirely. However, compensation payments are deductible by the corporation only if the compensated shareholder actually renders services to the corporation and the amount of the compensation is reasonable. Compensation payments that exceed a reasonable amount are not deductible by the payor corporation. In addition, corporate earnings that are paid out in the form of interest on corporate debt to shareholders or rents for the use of shareholder-owned property may be deductible by the corporation.
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WWW.FMSNEVADA.COM
info@fmsnevada.com
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