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Who should not elect to be taxed as an
"S" Corporation, and thus remain a "C" Corporation?
A business that will use it's profits to invest back into the business, such
as an inventory intensive business and a business where the shareholder
employee does not need to take a salary to provide for his/her
living needs. Why? If a business owner needs to
reinvest the businesses profits back into the business, then paying the
corporate income taxes at the low corporate rates of 15% and 25% on the first $75,000
will usually be cheaper than if the business was an "S" Corporation and the profits were taxed to
the owner. Same theory holds true for the business owner who does not intend
on taking a salary.
To avoid double tax the owner of a "C" Corporation may pay
himself/herself enough of a salary to wipe out the business profits.
As you can see, the payment of salary to a corporation's shareholder
employees has tremendous tax benefits and that is why IRS frequently
challenges an owner's salary
contending that the compensation is not reasonable. In fact, this is
one of the most common issues addressed by the Tax Court. Here are
some of the factors the courts use when considering whether a shareholder
employee's compensation is reasonable:
1.
Would an unrelated person, such as an investor,
consider the compensation
reasonable?
2. Did the Board of Directors vote on the salary level in
advance, or was the
salary determined just to wipe out the
corporate profits?
3. Is salary related to profits under a formula for
performance?
4. What is a comparable salary for someone in the same
industry?
5. What is the proportion of salary paid to the dividends
declared?
If your corporation will be considering a merger or acquisition of another
business, be aware that a "C" Corporation may be acquired by a
"C" Corporation or by an "S" Corporation, but that a
"C" Corporation may not acquire an "S" Corporation.
Also be cognizant that "C" Corporations are eligible to file
consolidated tax returns with an affiliated "C" Corporation.
For a corporation that will have excess funds to invest, the dividend
received deduction will save
a substantial amount of tax. Here is an example: If your "C"
Corporation buys 100 shares of General Electric and receives an annual
dividend of $140, it may exclude 70%, or $98, from corporate taxation.
Thus the corporation is taxed on only $42. Assume a corporate tax rate
of 15% and then the total corporate tax paid on $140 of dividends is $6.30,
which is less than one half of one percent of the total dividend.
Be aware of the accumulated earning tax (link to drawbacks) and the personal
holding company tax. The Personal Holding Company (PHC) tax is a flat
39.6% on undistributed PHC income. A PHC is any corporation where 5 or
fewer individuals own more than 50% of the outstanding stock for the last
half of
the corporations tax year AND where at least 60% of the corporation's
adjusted ordinary income consists of PHC income. PHC income is
interest, dividends, royalties, annuities, rents, amounts received under a
personal service contract and income from estates and trusts. Certain
types of corporations are never subject to the PHC tax such as banks, not for
profit corporations, life insurance companies, surety companies, and certain
lending and finance companies.
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