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Changes to the federal income tax code can prompt you to review the legal structure of your business. Last year’s increase in the top tax rate for individuals is one such change, since corporate rates remain the same. At the most basic level, businesses are taxed as either stand-alone or pass-through entities, and a significant difference between corporate and individual tax rates is reason for a new assessment.
If you’re debating between operating as a C corporation or an S corporation, here are three tax aspects to consider.
1.) Income taxes. A difference you’re probably aware of between the two types of corporations is the way earnings are taxed. C corporations are stand-alone entities and pay federal income tax at the corporate level, based on business earnings. If the corporation has a loss, the loss offsets business income in past or future years.
S corporation earnings and losses are passed through to you, as a shareholder. Earnings are taxed on your individual income tax return at your personal tax rate. This is true even if you receive no cash from the business. Losses can offset other income, assuming you participate in corporate business on a regular and substantial basis.
2.) Ownership. Tax rules limit the number and type of shareholders who can own an interest in your S corporation. For example, an S corporation can have no more than 100 shareholders, and they must all be U.S. citizens or residents. In addition, your S corporation can issue only one class of stock, meaning all shareholders have the same liquidation and distribution rights. When you form a C corporation, foreign owners can hold stock in your business. You can also issue stock with different ownership privileges, such as preferred stock, which grants priority in receiving corporate dividends.
3.) Dividends and distributions. In general, when corporate income is distributed to you as a shareholder, the distribution is a dividend. Whether your corporation is formed as a C corporation or an S corporation, the business gets no deduction.
However, as a C corporation shareholder, you’re required to include income distributions on your personal tax return. In effect, distributions are taxed twice, once on the corporate return and once on your return.
When you own stock in an S corporation, distributions can be considered a return of the money you invested in the business. The distinction means you may not owe income tax, assuming you have basis in the corporation.
Many tax and nontax reasons will affect your choice of the best type of structure for your business. Please call our office for a complete evaluation.