Two provisions in the 2003 tax law directly affect whether you should or should not be a C corporation (as opposed to an S corporation): First, the new maximum tax rate on ordinary income is now 35% (down from 38.6%); second, dividends paid by C corporations are now taxed at the same rates as long-term capital gains (maximum 15%, down from 20%). The 35% is scheduled to return to 38.6% in 2011, while the dividend break will end December 31, 2008.
Okay, you C corporation folks… listen up. Following are the "pros" and "cons" of staying a C corporation or electing S corporation status (Hint: nine of 10 corporations enjoy tax advantages as an S corporation).
S corporation "cons"
1. You probably would pay more income tax in current year. Make the computation, but remember: When you want to get those after-tax dollars out of your C corporation someday, you will be double taxed. Also, see "pros" 1. And consider the top individual rate and the C corporation rate are the same 35%.
2. Health insurance premiums for shareholders/employees and their families are not fully deductible.
3. Long-term care premiums for shareholders/employees -including spouses -are not fully deductible.
4. Any assets owned as of the date of the S election are subject to the "Built-in-Gain Tax" if sold within 10 years after the election. This tax is easy to avoid.
5. Use of a fiscal year is either not available or is impractical, usually forcing a December 31 year-end. (Rarely a consideration.)
6. The accumulated C corporation earnings would be permanently frozen at the date of S election. (No problem, those earnings are frozen anyway.)
7. Life insurance proceeds cannot be distributed from an S corporation until all S corporation and prior C corporation earnings have been paid out. (A corporation -C or S -should not own life insurance, period.)
Now, S corporation "pros"
1. Earnings, after making the S election, are not subject to double taxation and do not increase accumulated C corporation earnings. (Over time this is reason enough for most C corporations to switch to S.)
2. Opens up significant tax-saving estate planning opportunities. (The typical client saves over $1 million in taxes, including income tax, capital gains tax, and estate tax.)
3. Reasonable compensation becomes a non issue with the IRS.
4. Unreasonable surplus problems (often a big, costly deal) disappear.
5. An opportunity to divide family income among family members, which saves huge amounts of income tax and estate tax. The trick is to give nonvoting stock to kids and grandkids, while the founder keeps control by retaining the voting stock.
6. Dividends (automatic double taxation) aren't required. Sure, only 15% for C corp dividends is a low tax rate, but it's rather high when compared to zero for an S corporation.
7. Low capital gains tax rates instead of high ordinary income tax rates on sales of assets acquired by the corporation after S election or after the 10-year built-in-gains period.
8. The tax basis of your stock is increased dollar-for-dollar for undrawn profits. For example, if profits of the S corporation over a period of years was $900,000 and you only took $400,000 as tax-free dividends, the basis of your stock would increase by $500,000. If you sold your stock, that $500,000 would be tax-free. If you are thinking of selling, an S corporation is a must.
Burn this into your mind. There are only three good reasons to be a C corporation: (1) Your taxable profits are, and are likely to remain, under about $125,000, and also you need the after-tax dollars in the corporation to maintain growth or pay down debt. (2) You use the C corporation as a vehicle to get the benefit of deducting your health insurance and/or long-term care premiums. (3) You have carry-forward losses or other tax credits that would be lost if you make an S election.