By David E. Kolan, CPA, Managing Director
The pandemic has spurred a tsunami of entrepreneurial new businesses. According to the U.S. Census Bureau, a record 5.4 million new business applications were filed in 2021, compared to 4.4. million in 2020, compared to 3.5 million before the pandemic in 2019. Whether these ventures will prove successful remains to be seen, but each one will need to decide from the get-go the entity classification as a C corporation, an S corporation, a partnership, or a limited liability company (LLC). These decisions, made in the early stages of a business’s development, before hiring employees or earning profits, can have significant tax and financial implications on the company and the business owner, both today and far into the future.
When a business owner incorporates, the resulting entity is a C corporation by default, unless the business owner elects to be treated as an S corporation by filing Form 2553 within two months and 15 days after the beginning of the tax year in which the S election is to take effect. Determining the best legal structure for a business will depend on a wide variety of factors, including ownership, cash flow, cash burn, growth plans and even the owner’s eventual exit strategy. Moreover, as a business’s circumstances change, so do many of the costs and benefits of an initial entity selection. Thankfully, the choice of entity is not set in stone. Rather, U.S. tax laws allow owners to change their entity structures and adopt more tax-efficient strategies to meet evolving needs and goals.
Both C corporations and S corporations provide their owners with limited protection from the liabilities of the business entity. However, S corporations may only have one class of stock with ownership limited to 100 individual shareholders, all of whom must be U.S. citizens and/or domestic trusts and estates. By contrast, C corporations may have multiple classes of stock, and there are no limits on the number shareholders, which may include both foreign and domestic individuals as well as business entities. Therefore, a C corporation may be preferable to a business planning an IPO and/or seeking to raise capital from an unlimited number of foreign and domestic sources, some of whom may require ownership of preferred shares in the company’s stock.
Taxation of Income
From a tax perspective, C corporations are subject to two layers of tax: 1) the corporation pays federal taxes on its net income at a 21% rate, and 2) shareholders pay individual taxes on the dividends they receive from the corporation at their ordinary income tax rates, which are taxed at capital gains rates of 20% plus a 3.8% net investment income tax (NIIT). Depending on where shareholders live and where the business operates, additional taxes may be imposed at the state and local levels.
By contrast, a business may elect S corporation treatment as a “pass-through entity” (by timely filing IRS Form 2553) and avoid the risk of double taxation. The business’s income, losses, deductions, and credits “pass through” to shareholders who are responsible for reporting this information on their individual federal and state income tax returns and paying applicable taxes at their ordinary income tax rates. In some instances, however, shareholders may instead be subject to a 20% capital gains tax (plus potentially a 3.8% NIIT) on their distributive share of the S corporation’s income.
It is important to recognize that a C corporation may avoid double taxation by accumulating company earnings rather than paying dividends to shareholders. However, this may cause a C corporation to accumulate too much income and appear to be avoiding income taxes. In these situations, the IRS may force the business to pay dividends to shareholders or risk a 21% corporate-level tax on accumulated earnings exceeding its ordinary and reasonable needs.
While S corporations are generally not subject to this accumulated earnings tax, they are required to pay “reasonable compensation” to their owners or risk IRS scrutiny and the potential for all flow-through income to be treated as compensation to shareholders, taxable at their ordinary income tax rates.
Treatment of Tax Losses
No discussion about business taxes would be complete without mentioning the treatment of business losses. Tax losses from a C corporation (or that of a C corporation consolidated group) may be used to offset its future years’ taxable income, subject to certain limitations. C corporation shareholders cannot deduct these losses on their tax returns, nor may they receive any direct tax benefit for the losses.
Conversely, the losses of an S corporation flow through to its shareholders, who may claim those amounts as deductions on their individual tax returns, subject to an overall 2022 limit of $270,000 for individuals and $540,000 for couples filing joint income tax returns, provided they are actively involved in the business operations and have sufficient tax basis in their stock to absorb the loss. Those deductible losses essentially reduce the amount of shareholders’ income that is subject to tax.
With its single level of taxation, an S corporation is more tax efficient when it comes time to exit the business. Buyers prefer to purchase assets because they receive a tax basis equal to the purchase price, which reduces their post-acquisition cash taxes and improves cash flow. Sellers of S corporations generally pay capital gains rates of 20% on a business sale, but they may have some ordinary income due to depreciation recapture and other items. Buyers may gross up the purchase price to account for these additional taxes.
Conversely, sellers of C corporations generally prefer to sell stock to avoid the 21% tax at the corporate level and another tax of 20% (plus an additional 3.8% NIIT) on the distribution of the net proceeds that come with a sale of assets.
Tax Return Filings
When C corporations and S corporations operate separate businesses through subsidiaries owned by parent companies, tax laws permit them to file “consolidated” federal income tax returns and eliminate intercompany income and expenses.
An S corporation “consolidates” by having each subsidiary complete a QSub election, in which each QSub is disregarded for federal income tax purposes. Unlike a C corporation consolidated group, the consolidated S corporation is treated as a single taxpayer filing a single income tax return. However, a QSub may be considered a separate entity for state corporate law, employment tax and other non-income tax purposes.
David E. Kolan, CPA,