Subchapter “C” Taxation

Every corporation by default (automatically, unless it elects otherwise) and every limited liability company that specifically so elects (by filing IRS Form 8832) is taxed under Subchapter “C” of the IRS tax code. When paying federal income taxes on profits, a corporation or limited liability company taxed under Subchapter “C” is required to annually file Federal Form 1120 and state Form SC1120.

consultationWhereas corporations and limited liability companies are generally treated as separate entities for purposes of personal asset protection, taxation under Subchapter “C” allows taxing authorities to treat a business as a separate entity for income tax purposes. Separate entity status results in the double taxation of business profit from the perspective of a shareholder of a corporation or a member of an LLC. Tax on net profit is paid on the entity level according to a graduated tax rate, just like personal income tax. Thereafter, when the after-tax net profit is distributed to the shareholders or members, such distributions (or dividends, if a public corporation) are again subject to taxation as personal income to the shareholder or member. Thus, the same net profit is taxed twice, first on the entity level then on the shareholder level.

Public corporations can only be taxed under Subchapter “C.” Privately owned corporations, however, may elect to be taxed under Subchapter “S” rather than Subchapter “C.” Subchapter “S” taxation is often referred to as “pass through” taxation insofar as the net profit of the business is, for tax purposes, passed through to the shareholders or members and taxed in according to each shareholder’s or member’s personal income tax rate. Where Federal LLC taxation is concerned, LLCs are by default taxed as “pass through” entities, either as sole proprietorships or partnerships, were there also is no income tax on the entity level. For this reason, LLCs are generally not concerned with the possible need to avoid double taxation on net profits, in the way that corporations are.

While “double” taxation under Subchapter “C” is generally undesirable for smaller businesses or businesses owned by non-high net worth individuals, several factors may work in favor of Subchapter “C” taxation under certain circumstances. Thus, when choosing between Subchapter “C” taxation and Subchapter “S” election, a qualified tax advisor should be consulted, especially for individuals subject to higher tax brackets. For example, for income earned in 2005, assume that you have $50,000 in taxable income. If you are single, you will be in a 25.0% tax bracket. If you are married filing jointly, you will be in a 15.0% tax bracket. If your business is taxed under Subchapter “C,” then the business tax rate will be 15.0%. To further illustrate the impact the different rates can have, assume that you have $100,000 in taxable income. If you are single, you will be in a 28.0% tax bracket. If you are married filing jointly, you will be in a 25.0% tax bracket. A corporation with $100,000 in taxable income will be in a 34.0% tax bracket. The point being that the amount of income that your business generates is a factor to consider when deciding how to legally structure your business.

2005 Corporate Income Tax Rates

Taxable income over:

Not over

Tax rate

$0 to $

$50,000

15.0%

$50,000

$75,000

25.0%

$75,000

$100,000

34.0%

$100,000

$335,000

39.0%

$335,000

$10,000,000

34.0%

$10,000,000

$15,000,000

35.0%

$15,000,000

$18,333,333

38.0%

$18,333,333

-------------

35.0%

 

2005 Individual Income Tax Rates

Taxable income over:

Not over

Tax rate

$0

$7,300

10.0%

$7,300

$29,7000

15.0%

$29,700

$71,950

25.0%

$71,950

$150,150

28.0%

$150,150

$326,450

33.0%

$326,450

-------------

35.0%

 

2005 Married Filing Jointly Income Tax Rates

Taxable income over:

Not over

Tax rate

$0

$14,600

10.0%

$14,600

$59,400

15.0%

$59,400

$119,950

25.0%

$119,950

$182,800

28.0%

$182,800

$326,450

33.0%

$326,450

-------------

35.0%


2005 Personal Service Corporation

A personal service corporation (PSC)(a Subchapter “C” entity whose employees spend at least 95.0% percent of their time in the field of accounting, actuarial science, architecture, consulting, engineering, health, law, performing arts, or veterinary services) is taxed at a flat rate of 35.0% percent of net profits.

A personal holding company (PHC) (a business taxed under Subchapter “C” where 50.0% of the stock of which is owned by five or less individuals during the previous six months and 60.0% of the gross income for which comes from dividends, rents, royalties, or personal service contracts) must pay a tax of 15.0% on any undistributed personal holding company income in addition to other profit taxes (§542). On the bright side, however, small businesses with gross receipts of less than $5,000,000 will generally not be subject to an Alternate Minimum Tax (AMT).

2005 Alternative Minimum Tax Rates

26.0% on first $175,000 ($87,500 married, separate) of Alternative Minimum Taxable Income.
28.0% over $175,000 of AMTI (Alternative Minimum Taxable Income).

2005 Accumulated Earnings Tax

In addition to the regular tax, a corporation may be liable for an additional 15.0% tax on accumulated taxable income in excess of $250,000 ($150,000 for personal service corporations). (See IRS Code Sec. 531)

2005 Long-Term Capital Gains and Qualifying Distributions

5.0% for taxpayers in the 10.0% or 15.0% brackets.

15.0% for taxpayers in higher brackets.

The federal Subchapter “C” tax rate is significantly lower for income levels up to $75,000. Thus, when a business intends to retain all its earnings for an indefinite period of time in order to finance its growth internally, the Subchapter “C” tax rates can make Subchapter “C” taxation very attractive compared to pass-through entities for high income individuals. For example: Smith a high income taxpayer in the 35.0% tax bracket owns 100.0% of XYZ Corporation, taxed under Subchapter “C,” which made $75,000 in profit in its first year of operation. Using Subchapter “C,” Smith has the option of retaining all profit inside the corporation in order to facilitate business expansion and greater profitability. XYZ Corporation will therefore pay profit taxes at a rate of 15.0% on the first $50,000 of income and 25.0% on income from $50,001 to $75,000 in contrast to the 35.0% percent rate at Smith's individual level of which part or all of the income would be taxed at. Of course, if this profit is later converted into a dividend, double taxation principles apply. But in limited instances the positive effect of having increased cash for investment due to retained earnings and a lower initial tax rate may outweigh the negative effect of double taxation, especially for individuals in higher tax brackets.

In contrast to the lower entity level tax payment when compared to the individual tax rate and the retention of XYZ Corporation's earnings in the entity, a sole proprietorship or pass-through entity might have to distribute up to 35.0% of the income earned by the business in order to pay the individual federal income taxes on the income being passed through to Smith. Should Smith later simply sell her stock rather than convert XYZ Corporation's profits into a dividend, capital gains taxes would be accessed at a rate of 5.0% (if in the 10.0% or 15.0% bracket) or 15.0% (if in the higher brackets) rather than the substantially higher individual income tax rate.

Better still, in the event that XYZ Corporation later obtains Qualified Small Business Corporation (QSBC) status, and should Smith sell her stock rather than convert XYZ Corporation's profits into a dividend, she might be able to exclude 50.0% of the capital gains tax on the sales of her shares.

A Qualified Small Business Corporation (QSBC) is a Subchapter “C” entity eligible for a special tax break under the Internal Revenue Code. Specifically, holders of QSBC stock or membership rights may qualify for exclusion within established limits [IRC §1202(b)(1)] of up to 50.0% of their long-term capital gains from sales of shares or membership rights. A business taxed under Subchapter “C” generally qualifies for QBSC status if:

  1. During substantially all of the time the shareholder or member owns the shares or membership rights, the business does not hold more than 10.0% of its assets in the form of real property not used in the active conduct of a trade or business; and
  2. The business does not have cash and property with an aggregate adjusted basis in excess of $50,000,000; and
  3. During substantially all of the time the owner owns the shares or membership rights, at least 80.0% of the business’s gross assets are used in the active conduct of a qualified trade or business, which do not include the following, among others:
    • Providing personal or professional services;
    • Owning, dealing, or renting real property;
    • Farming;
    • Operating a motel, hotel, restaurant, or similar business; or
    • Banking, insurance, leasing, financing, investing, or similar business; and
  4. The owner is not another business taxed under Subchapter “C;”
  5. The time the owner has held the shares or membership rights exceeds five years;
  6. The shares or membership rights were acquired upon the original issuance in exchange for:
    • Money or property other than shares or membership rights; and
    • As compensation for services provided to the business; and
    • In a tax-free transfer or conversion

As has been shown, in forestalling paying shareholders or members distributions, a corporation or LLC owned by high income individuals can, under certain limited circumstances, increase its working capital through the greater accumulation of its earnings in contrast to pass-through entities. The business value of accumulating greater earnings is, of course, the accumulation of greater amounts of capital to support the business’s activities and to therein reinvest and profit from.

However, if the accumulations are not related to the reasonable business needs of the corporation, and if the corporation is audited by the IRS, an accumulated earnings tax of 15.0%, plus interest, may be levied against the unreasonably accumulated earnings, except to the extent that a corporation or LLC is eligible for an accumulated earnings credit. This credit permits small businesses to accumulate a minimum amount of earnings and profits, as well as that portion of the businesses earnings and profits that are required for any reasonable business purpose. On-going companies are allowed to accumulate, free of an accumulated earnings tax, the greater of (1) a minimum credit of $250,000 ($150,000 in the case of a corporation whose principle function is the performance of Accounting, Actuarial Science, Architecture, Consulting, Engineering, Health, Law, Performing Arts, and Veterinary services), or (2) such part (if any) of the taxable year’s earnings and profits (less the net capital and dividend gains from the company’s own internal investments) as is retained for the reasonable needs of the business. The first part of this rule, allowing a minimum credit of $250,000 (or $150,000) for accumulated earnings, is for the life of the business and is reduced by any accumulated earnings and profits that already exist at the close of the preceding tax year. The second part of this rule, however, carries no presumption that the minimum allowed credit is the maximum reasonable accumulation.

Every business owner might also keep in mind that not all corporate or LLC profit is subject to double taxation insofar as business expenses, including reasonable salaries to employees, (including employee-shareholders or members) as well as employee benefits, are deducted from corporate or LLC income prior to the determination of the entity’s income tax rate (though employee withholding taxes should also be calculated into the tax equation).

A entity taxed under Subchapter “C” that does not need to retain earnings for growth purposes (such as a personal service business) can often overcome double-taxation by simply making deductible payments—for salaries, bonuses, fringe-benefits (including retirement plan contributions), etc.—that directly benefit its shareholders or members. These payments, if considered reasonable when compared to standard payments for comparable work within the industry, can “zero-out” the corporation’s or LLC’s taxable income. When no taxable income is “inside” the corporation, the issue of double taxation becomes mute.

When attempting to zero-out a corporation or LLC’s taxable income, deductible payments that benefit shareholder-employees do not have to be limited to salary and fringe benefit payments. Shareholder-employees might also consider “capital structure” planning by capitalizing the business partly with shareholder loans and partly by leasing property (for example, an office building or necessary machinery or equipment) to the business. Using capital loans as a method of zeroing-out taxable business income also has the advantage of allowing the shareholder or member to recover the principle amount of the loan from the business without having it characterized as a taxable distribution.

One noteworthy risk when deducting expenses for taxation purposes, particularly for closely held business, is the temptation it creates for paying earnings though salaries rather than through distributions or for directing the business to pay for a shareholder’s or member’s personal expenses. A business avoids double taxation in doing so. But, the Internal Revenue Service may conclude that some of the salaries paid to a shareholder or member are actually constructive distributions, resulting in a large past due tax bill plus interest and penalties. Therefore, salaries generally should not be significantly more than is expected for any given business or industry. Moreover, corporations may be well advised to pay out at least some distributions each year and to avoid having the business pay for the personal expenses of the shareholders or members. A limited liability entity that pays for the personal expenses of its shareholders or members risks having its veil of limited liability pierced. For, if shareholders and members do not respect the boundaries between the corporation’s or LLC’s financial obligations and those of its shareholders or members, then courts, at the behest of any unpaid creditors, might not also be included to respect such boundaries.

Finally, it should be noted that the Internal Revenue Service is likely to look closely at transactions between a corporation or LLC and its shareholders or members in a closely held corporation to ensure that its transactions have been done according to “fair market” standards.


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