Coaching Program

2010-2

Tricks and Traps of C Corporations

Last time we talked in general terms about the difference between

incorporated and unincorporated business structures. We went through
each of the available business structure choices, and the situations
where each was ideally suited.
In this module, the goal is to get inside the C Corporation (or the
LLC-C), and determine when it’s time to fit this traditional and
invaluable structure into your business portfolio.

Why Everyone Needs a C Corp or an LLC-C

(Eventually)
There comes a point in every business owner or investor’s life where
a C Corporation becomes a good idea. Typically this is when your income
has reached a point where you are solidly into the top federal (and state)
tax brackets. The old top rate of 35% went away on January 1, 2009. Our
new top personal rate is 39.6%, and there are indications that high-
income earners will face more taxes over the next few years as the
administration looks for cash in the deepest pockets. Staying in an S
Corporation (or an LLC-S) at this point actually becomes counter-
productive. With careful tax planning you could reduce your taxes using a
C Corporation, even with the double-taxation issue.

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The C Corporation can also be a good idea if you want better

benefits to employee/owners than an S Corporation can give you
(without paying extra tax).

11 Questions to Help Make the C versus S Corporation

Decision
Here are 11 things to think about before you make your decision:
1. Will this corporation be your sole source of income, or do you
have other businesses or income streams?
2. Are you earning less than $250-300,000 per year?
3. Will you need all of the income from the corporation to live?
4. Do you expect to have a lot of losses in the early years of the
business?
5. Do you own all or a part of any other C Corporations?
6. Where do your shareholders (and potential shareholders) live?
7. How many other people are going to be involved in this
business?
8. Do you think your business may be suitable to take public at
some point?
9. Do you have a lot of uncovered medical expenses?
10. Do you have a need for staggered fiscal year-ends?
11. Are you using the corporation to operate a licensed,
professional business through?

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Primary or Secondary Source of Income?

In a C Corporation, you can draw a salary and also receive dividends.
But, the dividends come from your C Corporation’s after-tax profits and
become subject to tax on your personal return. So, your dividends wind
up being taxed twice: Once as C Corporation profits and again as capital
gain, when they hit your personal return. In recent years, this hasn’t
been as much of a factor as long as the corporate tax rate remained in
the lower tax brackets. That’s because the maximum individual tax rate
charged on capital gains was 15% and the lowest rate at the C
Corporation level was 15%. There have been a lot of changes this year
though, and unfortunately, that low tax rate is probably one of them for
you. The C Corporation double taxation is back to being a potential issue,
or at the last, a strategic planning opportunity.
In an S Corporation there is no double taxation. The company files a
tax return, but all of the salary and profit passes to you personally,
where it’s taxed, just once, at your personal level.
As your income level rises, so too does your tax bracket. Adding in
the salary and distributions from a S Corporation may accidentally push
you into a much higher tax bracket, or all the way up to the new 39.6
percent federal tax bracket.

Your Income Threshold

If you are earning less than about $250,000 to $300,000 per year,
even with the anticipated income from your new business, you might not
need a C Corporation quite yet. That’s because you’re probably not in

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the top income tax bracket. An S Corporation will be a better choice,

because you will be able to flow the income through to yourself as part
salary and part distribution to save on payroll taxes. You won’t need the
extra headache of strategically planning for payment from the C
Corporation to avoid the double taxation issue.
On the other hand, if your income, including the income from this
new business exceeds $300,000, you may be better off using a C
Corporation. C Corporations have their own tax brackets, which are often
lower than personal brackets. The first $50,000 in net income in a C
Corporation is taxed at 15 percent. If you were in an S Corporation, that
$50,000 in net income would come to you personally as a profit
distribution and be taxed at your personal rate … and that could be as
high as 39.6 percent. In a C Corporation, however, that net profit would
be taxed at the base C Corporation rate of 15 percent.

C Corporation Income Splitting Strategy

The strategy that we’re talking about here is called the “C
Corporation Income Splitting Strategy.” Instead of having all the income
hit at your personal level by using a flow-through entity, you take a part
of it and leave it within the C Corporation. You’ve split the income.
In the right circumstances, it’s an easy way to save $12,500 (tax
savings on $50,000 of income moved from individual to corporate.)

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Retained Earnings
Remember, though, in order to make the C Corporation income
splitting technique work, you need to be able to leave part of your
income inside the C Corporation every year. In other words, if you want
to move $50,000 from your personal income tax rate to the corporation,
the money has to stay within the corporation.
If you don’t need everything your business makes to live on each
month, a C Corporation can be an excellent addition to your structure
portfolio.
C Corporations are also the only entity that can choose whether or
not to disburse the profits from the business. With S Corporations and the
other flow-through structures, the IRS considers all the profit each year
disbursed, and taxes you on it – whether or not the money is actually
distributed.
In a C Corporation, undisbursed profits are called retained earnings.
C Corporations may retain up to $50,000 of after-tax profits each year
with no tax consequences. (Once a C Corporation accumulates $250,000
in retained earnings it may become subject to an excess profits tax).
The great thing about retained earnings is your ability to divert that
money into other business investments, other projects, a pension … all
kinds of things that don’t require you to pull the money into your
personal account (and onto your personal tax return). So, if you wanted
to use the excess profits to invest in a real estate venture, for example,
you could have the C Corporation loan money from its retained earnings
to an LLC, which will buy and hold the property. Because the money

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went out of the C Corporation as a loan, it won’t be considered a taxable

withdrawal to you personally, nor will it be considered taxable income as
it’s repaid. This can be an incredibly powerful strategy for smart
investors!

Early Stage Losses

Will your business lose money in the early days? There’s a reason
most businesses begin life as S Corporations. That’s because C
Corporations, unlike S Corporations, may not flow their losses through to
the owners personally. Because the C Corporation pays tax at its own
rate, it has to deal with the losses internally as well, and use them to
offset its income. If the C Corporation has more losses than income,
anything left over gets suspended, and carried forward until there is
enough income to complete writing off the losses.
In an S Corporation it’s different. Losses flow through to your
personal return, just the same way profits do. Now, if you’ve got more
losses than profit, the losses can be offset against your other income.
This is something our high-earner clients love. The ability to take
business losses against other active or passive income can really bring
down their personal tax bills!
The rule of thumb here is to first look at your current income level.
If the business is your primary source of income and you are taking
$50,000 or less out of the business, then an S Corporation is your choice.
If you have multiple sources of income and are already in a high tax

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bracket – and especially if you don’t need all of the income from the
corporation each year – then the C Corporation may be worth looking at.

Controlled Groups
The controlled group is a gotcha that snags many of our clients!
If you own a majority interest (50 percent or more) in more than one
C Corporation, your corporations will be considered a controlled group by
the IRS.
When the same person (or a group of related persons) controls
multiple C Corporations a controlled group is created, and the C
Corporations are all collapsed into a single C Corporation for tax
purposes. Now, all of the C Corporations’ incomes are added together
and taxed at the aggregate rate.
Let’s say you had three C Corporations, each with $50,000 in net
profits. You should be able to file 3 separate tax returns, and pay 15
percent income tax on each Corporation’s net earnings. Right?
Wrong. Under IRS controlled group rules, you would first have to add
all the income together, and then calculate your tax based on the new
net of $150,000. That’s going to result in a much higher corporate tax
rate.
And, in addition to treating the C Corporations as one entity for
calculating tax, you must also aggregate certain deductions as well. So
again, if you owned three C Corporations you’d have to spread one
Section 179 deduction across all three corporations. Instead of having a
potential of $750,000 in deductions for 2009 ($250,000 x 3), you're

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limited to a single $250,000 deduction. This amount will be lowered in

future years, too, as the Section 179 expensing limits were artificially
inflated this year under the stimulus legislation and will revert back to
$125,000 per year in 2010 and beyond.
The news isn’t all bad though. While you lose many of the tax
benefits with a controlled group there is no impact on liability. Under the
law each C Corporation is still considered to be a separate entity. So
even though you might file one consolidated tax return, a problem on C
Corporation 1 won’t affect C Corporations 2 and 3.
The best way to avoid controlled group status is not to have one. If
you already own 50 percent or more of a C Corporation, then make sure
you set up your other entities as S Corporations or LLC-S’s. Because of
their flow-through tax status, S Corporations and LLC-S’s are not subject
to the controlled group regulations.

Where Are Your Shareholders

If you have or are planning to have shareholders who live outside of
the United States, then the only way to do this is to use a C Corporation.
The reason comes back to taxes. In an S Corporation, the taxes are paid
by the owners. If the owners don’t live in the United States, the money
would flow out of the country without taxation. That’s not something the
IRS wants to aid or encourage, hence the requirement that all
shareholders be U.S. residents, and file a U.S. tax return each year.
Shareholders are also required to be natural persons or personally-owned
trusts – again, purely to prevent untaxed dollars from escaping the IRS.

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If you think you may have foreign residents who will want to invest
in your corporation now or in the future, then you may be better served
by starting off as a C Corporation, rather than beginning as an
S Corporation and changing your corporation’s tax structure down the
road.

How Many Shareholders Will Your Business Have?

Another S Corporation limitation is on the number of shareholders it
may have – S Corporations are limited to 100 shareholders only. If you are
looking to grow your corporation into a larger business, and, in particular
if you are looking at taking it public or even carrying out a private
corporation financing (like a private placement offering), then you may
be better served to use a C Corporation. While you can certainly begin as
an S Corporation and change to C Corporation status later, there will be
additional accounting and bookkeeping costs as you switch the
corporation’s records over to the new system.

Will Your Business Grow and Become a Public Company?

There is really only one way to go public, and that’s through a
C Corporation. Nothing else is flexible enough to give you access to the
widest possible shareholder base while maintaining control over business
operations. Remember, S Corporations are limited in both the number of
shareholders and their locations. C Corporations, on the other hand, can
have a limitless number of shareholders, who may reside anywhere in the
world.

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Another huge advantage C Corporations have over S Corporations is

their ability to have multiple classes of stock, whereas S Corporations are
limited to one type only. This can be enormously helpful when you are
trying to design a structure that will let you stay in control as your
business grows and more shares are issued. One common method is to
issue preferred, non-voting stock to a corporation’s founders, which can
then be converted to voting stock when the corporation goes public. Now
the founders can stay in control, even after several new million public
shares have been added to the corporation’s bank of issued shares
(called a treasury).

Medical Insurance
If the ability to maximize loopholes and tax deductions is your
overriding factor, then you should know that a C Corporation has more
tax loopholes and deductions available to it than S Corporations, LLCs or
LPs.
On example is medical insurance. C Corporations can establish a
medical insurance plan and write off all of the costs associated with that
plan. So can S Corporations. But, there’s a big difference in how those
benefits are taxed.
In a C Corporation, the amount of money paid out on behalf of the
employees for healthcare is an expense to the business. It’s also a non-
taxable deduction for the employee … or at least it was at the time we
wrote this (our new administration has not ruled out taxing all or a part
of healthcare benefits to fund upcoming programs). So, while your

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insurance costs may be $1,200 per month for yourself and your family,
you don’t see an extra $14,400 reported on your W-2 each year. The C
Corporation treats that $14,400 as a deductible expense – part of its cost
of doing business.
It’s not that easy if you own 2 percent or more of an S Corporation’s
stock. The Corporation gets the deduction, but you may have to pay tax
on some, if not all, of the medical insurance benefit.

Medical Expense Reimbursement Plan

The Medical Expense Reimbursement Plan (MERP) is commonly
confused with a regular medical insurance plan, but it is actually so much
more. With a MERP, the employee can spend a certain amount each year
on medical expenses and then be reimbursed directly from the C
Corporation for those expenses. The annual amount is set by the
corporation. So, let’s say you have a C Corporation where you and your
spouse are the only employees. As long as you don’t control any other
companies that have employees, you can offer an unlimited MERP. Every
qualifying medical expense that you incur, expected or unexpected, can
be reimbursed by the C Corporation for a full deduction.
The MERP is better than some of the other before-tax medical plans
such as HSA, MSA, cafeteria or Section 125. With these other types of
plans, you have an amount withheld from every paycheck. It is then held
in a fund that you can use to get reimbursement from. There are two
disadvantages to this program: (1) You have to determine a year in
advance how much you want withheld. Unlike the MERP, there is no way

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to pay for an unexpected medical cost. (2) You are limited by law to the
amount that can be paid each year. The MERP’s limits are set by the C
Corporation’s board of directors.
You can also set up a MERP with a Sole Proprietorship or a single
member LLC that has default taxation (which means a Sole
Proprietorship). There is one more step here. The owner of the Sole
Proprietorship cannot have the MERP. Only the SPOUSE of the MERP can.
So if you’re not married, you’re out of luck. If you are married, set your
spouse up with a paycheck before the end of the year to take advantage
of this!

Staggered Year-Ends
This is another great loophole C Corporations (and LLC-Cs) have that
no other business entity does: the ability to select their own fiscal year-
end. All of the tax flow-through structures are stuck with the same fiscal
year-end you are, being December 31st.
The problem with all of your businesses closing their books on
December 31st is that it doesn’t always give you enough time to plan,
particularly where you’ve got multiple business streams of income that
can either be inconsistent, or tend to pay off at different times. You
could wind up either with a huge pile of money that artificially inflates
your overall tax rate. Or, you could find that you’ve done all of your
year-end billings and have a big tax bill for money that isn’t yet
collected. Even worse, right at the exact time you may need your
accountant or tax advisor’s undivided attention – such as how best to

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structure a windfall or shortfall – they are buried under OPTR (other

people’s tax returns), and the answers you get are either late,
incomplete or not properly thought through.
By having a C Corporation in your business mix you can often
alleviate some of the pain through layering of structures. A C Corporation
could be paid a management fee, or a commission of some sort, which
would allow you to pull windfall money out of the S Corporation and off
your personal tax bill. By selecting a different year-end date for the C
Corporation – i.e., June 30th or August 31st (you can use a traditional
calendar quarter or select a random month-end), you’ve got a safety
valve for that money. It can stay in the C Corporation until the December
31st tax-time crunch has passed, and your CPA/Tax Strategist has the
time they need to best help you to manage this income.

Professional and Licensed Businesses

Depending on the type of business that you have, the IRS can tag you
with some additional designators, like professional, qualified personal
service, and personal holding. Each of these designations can impact how
your corporation is taxed, and can be important factors on influencing
when to use a C Corporation over an S Corporation, and vice-versa.

Professional Corporations
We’re frequently asked about Professional Corporations and whether
they are appropriate business choices.

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As a rule, "professional" status for corporations is reserved for

businesses where all of the owners are required to hold the same
professional license. Depending on your state, you may be able to use
any of the three incorporated structures (C or S Corporation, LLC, or LP)
as professional businesses.
Professional structures are specifically designed for this purpose.
Ownership in these structures is usually restricted only to those
professionals who are properly licensed. For example, if you use a
professional corporation to form a law firm, then each shareholder of the
corporation would need to be a licensed attorney. However, there are a
number of states that permit non-licensed spouses to also hold stock or
interests in a professional entity.
The liability rules for these structures are also different. Generally
speaking, professionals remain liable for their acts and deeds, no matter
what type of business structure they operate through. If your attorney or
CPA does something wrong and causes you to be sued or to lose money,
you have a right of action against that attorney or CPA, as well as the
firm he or she belongs to. Professional structures allow these individuals
to work together as a group while having some personal liability
protection from each other. In other words, if one doctor is sued for
malpractice, it remains a personal suit against that doctor and against
the medical practice. The other doctors cannot be personally named to
the lawsuit.
Because they are specialized structures, professional structures are
not intended to be used for other, non-related businesses. For example,

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if a group of doctors got together to invest in a real estate project like a

shopping center, the group wouldn't use a professional LLC or LP for this
purpose. They are not providing medical services through this business
structure, so they are free to use a regular LLC or LP. This would also
allow doctors to hold ownership jointly with spouses or children, which
they couldn't do otherwise unless their spouses or children were also
doctors.
In many states, forming a professional corporation means you’ll need
the pre-approval of your state licensing board before your corporation’s
paperwork will be filed. In other states, you are required to first
incorporate your business structure with the secretary of state’s office,
and then register it again with your local state licensing board. So, one of
the first steps for any professional is to first determine: (a) whether or
not you need to operate through a professional entity, and (b) whether
you can use a professional corporation or a professional LLC. We prefer
to use professional LLCs over corporations where possible. The LLC can
choose how it wants to be taxed, and your ownership in the professional
LLC will receive additional asset protection (if you are a sued in a non-
professional capacity). For example, if your teenager causes a car
accident and you get sued as the vehicle owner, you could better protect
your interests in a professional LLC than you could in a professional
corporation.
Unfortunately, states are inconsistent on whether or not a
professional business can be a corporation or an LLC. The best way to
find out if you need to operate through a professional corporation is to

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contact your licensing board and ask them what their local requirements
are.
States are also inconsistent on the list of professionals required to
incorporate as a professional corporation. Generally speaking, if your
profession requires you to be licensed and you need to belong to a state
or federal regulatory body, you may need to operate through a
professional corporation.
Here are some of the most common occupations that must be
operated through professional corporations. Again, contact your local
licensing board if you have any questions about your own profession.
 Accountants
 Engineers
 Health care professionals, such as audiologists, dentists,
nurses, opticians, optometrists, pharmacists, physical
therapists, physicians, and speech pathologists
 Lawyers
 Psychologists
 Social workers
 Veterinarians

Taxing a Professional Corporation

Professional corporations can choose how they want to be taxed.
Whether you use a corporation or an LLC, you can elect either C
Corporation taxation or S corporation taxation. That classification does
not matter to your state licensing board. But there are still some tax

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issues to consider, particularly if your business is also considered to be a

qualified personal service corporation.

Qualified Personal Service Corporation

The IRS defines a qualified personal service corporation (sometimes
called a QPS or a PSC) as a specific type of business where the owner-
shareholder provides his or her own services for the corporation.
The IRS considers most professional corporations to also be personal
service corporations. In addition, though, the IRS has recently added
actuaries, performing artists, and consulting companies – businesses that
generally aren’t required to be professional corporations – to the list.
A qualified personal service corporation is subject to a flat tax of
35 percent and has a lower threshold for accumulated earnings tax than
a regular C Corporation. That means the traditional lower C Corporation
rates no longer apply, which means you’ll pay a higher tax bill.
A qualified personal service corporation is also required to have a
December 31st fiscal year-end, eliminating any tax-timing benefits
normally available to C Corporations with staggered year-ends.
If you think your business might be considered a qualified personal
service corporation, you have two options. You can:
 Operate as an S Corporation. The IRS considers the flow-
through tax status of an S Corporation to offset the 35 percent
rate it would normally levy; or
 Try to fail the IRS qualified personal service company test.

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There are two ways to fail the test. One way is to show that less
than 95 percent of all employees’ time is spent in personal service
company activities. For example, most veterinarians also offer animal
boarding and care. As long as the veterinary practice can show that its
employees are spending at least five percent of their time caring for
boarded pets, the practice can operate as a C Corporation without being
tagged as a qualified personal service corporation. Now the veterinary
practice can enjoy all of the standard C Corporation benefits.
We see this with optometrists too. Have you ever visited your eye
specialist and been able to buy your glasses, frames and contact lenses
on site as well? How about a chiropractor who also sells relaxation
materials, a doctor’s office that sells vitamin supplements, and so on?
The same theory is at work here – by offering services that are not PSC
related, the owners can fail the personal service company test.
The second way to fail the test is to make sure that at least five
percent of the corporation’s stock is held by persons who aren’t
personally providing the professional service. If you’re lucky enough to
be in a state that permits non-licensed spouses to also hold ownership in
a professional corporation or professional LLC, this is easy – make sure
your spouse (or spouses, if there are multiple owners involved) own five
percent or more.

Personal Holding Company

The personal holding company is a corporation that has been
established for the main purpose of collecting dividends, interest, and

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other solely passive investment income. It’s defined as a C Corporation

that is owned by 1 to 5 individuals, who together control 50 percent or
more of its stock, and earns 60 percent or more of its earnings through
passive income.
The problem with being classified as a personal holding company is
the increased taxes that go along with that classification. Personal
holding companies are taxed on their retained earnings on top of the
regular corporate income taxes. From 2003 to 2008 that extra tax was
lowered to 15 percent through the Jobs and Growth Tax Relief
Reconciliation Act of 2003. But that provision has now expired, and the
tax rate on retained earnings has returned to its former rate of 35
percent. LLCs are not subject to this tax – one more reason why the LLC
is such an attractive structure to hold passive investments. S
Corporations are also not subject to this tax, but they don’t offer the
same high level of asset protection as the LLC.

Accumulated Earnings (or Retained Earnings) Tax

When a C Corporation goes over the $50,000 per year ($250,000
accumulated) retained earnings cap set by the IRS that money becomes
subject to something called the “retained earnings tax.” This is a tax the
federal government set up to make sure that C Corporations distribute
profits from time to time. The Feds saw it like this: the more retained
earnings a company has, the more attractive it becomes to investors. The
more attractive the investment, the longer an investor will want to hang
onto it. And, the longer an investment is static, the lower the tax

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revenue. Remember, the government doesn’t get paid until the stock
gets sold and the investor pays the tax on the buy price versus the sell
price.
The government determined that by installing a tax on retained
earnings, sooner or later, a C Corporation would rather put the onus on
paying this tax onto its investors instead, and if the tax was high enough,
even the largest investors wouldn’t be able to persuade a C Corporation
not to distribute its profits at some point. And once those profits were
distributed, the government could collect capital gains tax from the
investors.
A great example of this is Microsoft. In July of 2004, Microsoft had
retained earnings of approximately $60 billion and was paying dividends
of around $0.16 per share each year. Investors were wondering if they
would ever get some serious money out of the business, short of selling
their shares. Well, in the July 2004 announcement, Microsoft stated that
in December 2004 it would make a one-time dividend payout to its
shareholders of about $32 billion, along with doubling its annual dividend
rate to $0.32 per share.
Why had Microsoft held out so long? There are many reasons, but
one of the most commonly-cited ones was that Bill Gates had held up the
dividend payout because of the impact it would have on his taxes.
Because of his position as a major shareholder, Mr. Gates had the clout
to persuade the directors to hold off on paying out distributions. When
they were paid out, Bill Gates received some $3.6 billion and donated

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the entire amount to charity, offsetting the tax hit he would otherwise
have faced on such a huge windfall.

Nexus
Nexus is yet another issue to consider when choosing between a C or
an S Corporation. Earlier we outlined the C Corporation Income Splitting
Strategy. This strategy works great in states like Nevada and Wyoming,
which have no state personal or corporate income tax. If you’ve got a C
Corporation with $50,000 or less in retained earnings, that money can sit
in the Corporation’s Nevada or Wyoming bank account without any
personal taxes accruing. When you take money from the company in the
form of salary or dividends, you’ll have to pay tax both at the federal and
state level.
But if you were to use an S Corporation or another flow-through
entity in Nevada or Wyoming the results would be different. You lose the
ability to retain earnings, meaning that every dollar of profit is
considered by tax authorities to have been distributed to the owners
every year. That’s why we only recommend our clients use Nevada or
Wyoming corporations in very specific circumstances.

Appreciating Assets
In general you never want to have appreciating assets such as real
estate held within a C Corporation. To demonstrate why, let’s go
through an example of holding property inside an LLC (limited liability
company) versus a C Corporation.

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Let’s say you and your partner buy a property for $600,000. Over
time the property appreciates to $2,000,000 and you sell the property.

In an LLC: You have gain of $1,400,000 that is split between you and
your partner. The $700,000 each is taxed as long-term capital gains.
Assuming you are paying at the top long-term capital gains rate of
20%, the tax per partner would be: $140,000

In a C Corporation: You have a gain of $1,400,000 that is taxed at

the top C Corporate tax rate of 35%. The tax per partner would be:
$245,000
But it doesn’t stop there. All the money is still held within the C
Corporation. How are you going to get it out? If you take it out as
dividends, it’ll be taxed again.

The moral of the story is: Do NOT put appreciating assets inside a C
Corporation.

Should You Have a C Corporation?

Hopefully, after you’ve gone through all of this information you have
the only right answer for the question: Should I have a C Corporation?
And that answer is: IT DEPENDS!
A C Corporation can be a wonderful tool, if it meets your needs. If
it’s not the right fit, it can be cumbersome and expensive to run.

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