When starting a business one of the most important decisions to make is your entity’s structure. One common entity structure is a C corporation. The different types of entity structures each have their own advantages and disadvantages. The best option will depend upon your specific situation. Some common factors to consider when choosing a structure include your personal financial and tax situation, liability protection, and your ability to raise capital.
Here’s a detailed look at the pros and cons of operating as a C corporation.
Tax Implications
A C corporation is a separate taxable entity. This means that the corporation pays the tax on its income at the entity level, rather than being passed through to the owner’s personal return. The corporate tax rate currently sits at 21%, which is well below the top personal income tax bracket of 37%. While the lower corporate tax rate is appealing, it does not always mean a lower net tax liability for your combined business and personal tax situation. This is due to double taxation.
Double taxation is one of the primary disadvantages of the corporate entity structure. Double taxation occurs when the corporation’s profits are taxed at the corporate level and then again when dividends are distributed to shareholders at the individual level. This can result in a higher overall tax burden than other business structures. Even though these dividends are subject to significant tax, corporate earnings can still be taken out of the entity in the form of a reasonable salary. These wages are tax deductible at the corporate level, ultimately providing relief from double taxation.
The separate nature of a corporate tax structure means that while income is taxed at the entity level, so are losses. This is a potential disadvantage if you anticipate losses as the business gets started. These losses can be carried forward indefinitely, however, they can only offset 80% of taxable income in any one tax period. While these losses can still provide a tax benefit in future years their strict rules for use at only the corporate level are a disadvantage.
Liability Protection
The separate entity treatment that limits your tax planning options, redeems itself by offering a significant advantage in its limited liability protection. Ultimately, the shareholders aren’t personally liable for the corporation’s debts and liabilities. This means personal assets are generally protected if the business faces legal issues or bankruptcy.
Complying with Requirements
With this separate entity treatment comes additional “red tape” in the form of various state reporting and operating requirements.
These include:
- Filing articles of incorporation,
- Adopting bylaws,
- Electing a board of directors,
- Holding organizational meetings, and
- Keeping minutes of meetings.
Complying with these requirements and maintaining an adequate capital structure will ensure you don’t inadvertently risk personal liability for the business’s debts.
Fringe Benefits
A C corporation can also be used to provide fringe benefits and fund qualified pension plans on a tax-favored basis. Subject to certain limits, the corporation can deduct the cost of a variety of benefits such as health insurance and group life insurance without adverse tax consequences to you. Similarly, contributions to qualified pension plans are usually deductible but aren’t currently taxable to you.
Raising capital
A C corporation also gives you considerable flexibility in raising capital from outside investors or debtors. Unlike other entity structures, a C corporation can have multiple classes of stock. These different classes can have their own rights and preferences such as voting abilities and dividend requirements that may be appealing to investors. Debt can also be a powerful source of capital for a C corporation as the interest paid by the corporation is tax deductible.
The Right Fit
The corporate entity structure may not always be the right fit, even if it is at this time. If that is the case, there is an option to convert to an S corporation in the future. There are certain requirements regarding the entity itself, the shareholders and the classes of stock that must be met to be eligible for S corporation treatment. The conversion to an S corporation is typically tax-free, except for certain built-in gains. These built-in gains occur when the entity disposes of certain corporate assets within 5 years of the S election.
This is only a brief overview of the pros and cons of being a C corporation. Ultimately, the best entity structure will depend on your specific situation. Contact us if you have questions or would like to explore the best choice of entity for your business.
