As you likely know, the Tax Cuts and Jobs Act made a big change in how C corporations are taxed—one flat, 21 percent rate.
The new, lower rate makes the C corporation far more appealing than in prior years. But you also need to look at the dark side of this possible opportunity.
Double Taxation of Corporate Dividends
Say you run your business as a C corporation. The business is successful, and your corporation builds up a hefty amount of earnings and profits (E&P).
While lots of E&P (a tax accounting concept similar to the financial accounting concept of retained earnings) indicates a financially healthy operation, it also creates tax concerns when you try to get money out of the company.
Double Taxation of Dividends Explained
To the extent your C corporation has current or accumulated E&P, non-liquidating corporate distributions to shareholders (like you) count as taxable dividends.
Since the current federal income tax rate on dividends received by individuals cannot exceed 23.8 percent (the 20 percent maximum rate plus 3.8 percent for the net investment income tax, or NIIT), dividends paid while the current rates are in force will be taxed relatively lightly.
Accumulated Earnings Tax Can Be Assessed If Dividends Are Not Paid Out
You might ask: “Can’t my C corporation avoid the double-taxation problem simply by not paying dividends?” Answer: that may not work.
When your C corporation retains a significant amount of earnings rather than paying them out as double-taxed dividends, there’s a risk of the IRS hitting the company with the dreaded accumulated earnings tax.
Accumulated Earnings Tax Explained
The accumulated earnings tax is a corporate-level tax assessed by the IRS, as opposed to a tax that is paid voluntarily with your company’s corporate tax return.
The IRS can assess the accumulated earnings tax when (1) the corporation’s accumulated earnings exceed $250,000, or $150,000 for a personal service corporation, and (2) the corporation cannot demonstrate economic need for the “excess” accumulated earnings.
When the accumulated earnings tax is assessed, the rate is the same as the maximum federal rate on dividends received by individual taxpayers (currently 20 percent).
Zeroing Out Corporate Taxable Income with Compensation Paid to Shareholder-Employees Is Not Foolproof
Okay, so you now understand that C corporation dividends are potentially subject to double taxation, and that not paying dividends could trigger the dreaded accumulated earnings tax.
“So,” you ask, “why not just pay out all or nearly all of my C corporation’s annual profits as tax-deductible compensation to me (and other shareholder-employees, if any)?” That way, you avoid double taxation because your corporation’s taxable income is zeroed out (or nearly so).
You’ll have to pay personal income taxes on the compensation, but that’s okay, because the current federal income tax rates are pretty low by historical standards. Great idea! But . . .
The zero-out strategy works only as long as the purported compensation paid to the shareholder-employee(s) is “reasonable.” If the purported compensation exceeds what’s deemed reasonable, and if the IRS discovers this during an audit, the IRS can reclassify some or all of the purported compensation as double-taxed disguised dividends.
Needless to say, the issue of what constitutes reasonable compensation has been the subject of much litigation between the IRS and taxpayers.
Case in Point
In a 2016 decision, the Tax Court upheld IRS-assessed additional taxes and penalties against a law corporation that claimed compensation deductions for purported year-end bonuses paid to shareholder-employees. The purported bonuses were found to be disguised dividends.
The claimed bonus deductions completely eliminated the corporation’s book income, even though the corporation had income from substantial invested capital.
So, the corporation failed the hypothetical independent investor test, which indicated that the purported bonuses were not reasonable compensation. Other factors supported the finding that the purported bonuses were disguised dividends.
- In the right circumstances, operating your business as a C corporation rather than as a pass-through entity can be a tax-smart move.
- But be aware of the tax caveats surrounding C corporation status.
- When evaluating the C corporation option, consider the possibility of future unfavorable changes to the federal income tax regime.