While most new businesses are set up as pass-throughs nowadays, C corporations still have a following. Martin Sullivan ponders why taxpayers voluntarily run a business in a way that they know will be subject to two taxes:

Graduated corporate rates, the low rate on corporate dividends, and an exemption from payroll taxes combine to make subchapter C the most advantageous choice for a lot of small business profits. If a business owner can afford to leave profits inside the corporation, the resulting deferral of individual tax only makes subchapter C more attractive.

Pass-throughs — S corporations and partnerships — don’t pay taxes on their income. It instead “passes through” to the personal returns of the owners. The top individual and corporate rates are both 35%, but C corporations are taxed at a 15% rate on their first $50,000 of income. If you are in a 35% personal bracket, having additional income taxed at 15% is attractive, even if you have to pay a second 15% tax to withdraw the earnings as as a dividend. C corporations also provide some fringe benefits unavailable to pass-through owners.
So what’s not to like about the C corporation?
- Your corporation can’t grow very big and still use the low rates. Once corporation taxable income exceeds $100,000, a “phase-out” rate of 39% starts to recapture the benefit of the lower brackets. Once taxable income hits $335,000, a flat 35% rate applies to all corporation income.
- You can only get that corporate 15% bracket once. You can’t set up multiple corporations to get multiple 15% brackets.
- Using the 15% rate requires an ability to monitor and control corporate taxable income. That requires time, effort and expense.
-”Personal service corporations,” including law, medical, accounting and consulting practices, don’t get the lower brackets. They pay a 35% rate starting with the first dollar of taxable income.
-Assets inside the corporation are trapped there. The tax law treats distributions of appreciated property as taxable sales, but losses on distributions are normally not allowed.
- If you sell the business, the C corporation can get very expensive. There is no capital gain break in computing C corporation taxes. Most business buyers prefer not to buy stock because they don’t want to inherit any unconfessed sins of the old corporation. If the assets have gone up in value, you probably have a 35% tax on the asset sale, and a 15% capital gain on the liquidation on top of that. In a pass-through, you will have just one tax, and likely it will mostly be at the 15% capital gain rate.
As long as there is a 15% corporate rate bracket and a 15% dividend rate, C corporations will remain tempting. Still, it is wise to ponder the words of tax sages Bittker and Eustice:

Decisions to embrace the corporate form of organization should be carefully considered, since a corporation is like a lobster pot: easy to enter, difficult to live in, and painful to get out of.

Flickr image of lobster pots courtesy easylocum under Creative Commons license
Related: Corporations: yea or nay?

Tags: C corporations, lobster pots, Martin Sullivan, pass-throughs, S corporations, tax.com

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