Question most CPAs as to what business form they suggest for the business clients and they typically answer, “A C Corporation—at least in the early capital formation years of the business.” Ask any Investment Banker or other Transaction Advisor what entity they prefer and you will likely hear, “An S Corporation or LLC (Limited Liability Company), or perhaps a partnership or sole proprietorship. Anything, anything, but a C Corporation!”

Whose advice do you follow? More importantly, how do you decide what is the best form of business for you? Let’s look at the income tax features of both the regular corporations.

What difference does it make?

TAX ATTRIBUTES OF A C CORPORATION

A C Corporation enjoys income tax brackets separate from those of its owners. For the first $50,000 of taxable income retained in the corporation, the federal tax bite is 15 percent. The next bracket applies to $50,000 to $75,000 of retained taxable income and imposes a 25 percent tax rate; from $75,000 to $100,000 the rate is 34 percent; and above $100,000 an additional five percent tax applies to phase out the benefits of these graduated rates. The capital gain rate is a flat 34 percent.

Most businesses, at least in their infancy, need to retain earnings at the business level to fund expansion. For this reason, the C Corporation form may be best because it pays less tax, especially on the first $100,000 of annual retained earnings, than an individual or flow-through entity. Thus, C Corporation status offers significant benefit to a growing business. But beware of simple solutions.

The C Corporation’s greatest attribute can be its greatest weakness. Precisely because a C Corporation is a separate taxable entity it pays a tax whenever it sells anything it owns for gain. Imagine a buyer approaching your business with an offer to buy all of its assets for $1 million. Upon receipt of the $1 million, your C Corporation will pay a tax on all of the gain. So far, so good. The federal tax will not exceed 35 percent and will likely be less depending upon the basis in the assets sold.

Next, however, imagine that you wish to use the cash proceeds for your personal benefit. As soon as you touch the cash from your C Corporation, you will trigger a tax avalanche. The IRS will deem this transaction to be a dividend and tax you at 15 percent and you will pay any state tax that applies. Alternatively, you might wish to liquidate the C Corporation and use the lower capital gain rate (also 15% plus any state tax rates). Remember, your C Corporation already paid a tax. Now, you pay a second tax on the proceeds from the assets of the business that you in turn receive from the business.

TAX ATTRIBUTES OF AN S CORPORATION

Any taxable income retained at the S Corporation level is taxed at the owner’s individual income tax bracket. Once taxed, when that money is paid to an owner in a future year there is not a second tax because the owner is considered, for income tax purposes, to own that asset on which a tax has already been paid.

Thus, when a business is sold for $1 million, the total tax consequences affecting the seller’s proceeds is a one-time capital gain on the net gain. The owner, then, avoids the second tax which is incurred when a C Corporation distributes the net proceeds to its owners, and takes advantage of the much lower personal capital gains rate of 15 percent, rather than the C Corporation rate of 34 percent.

In addition, an S Corporation also avoids issues of unreasonable compensation and excess accumulation of earnings because all earnings are taxed directly to the owner in the year earned. Also, FICA expenses can be reduced by attributing some of the money the owner receives each year to Subchapter S dividends as opposed to compensation. Subchapter S dividends are not subject to FICA.