"C" Corporation versus "S" Corporation Entity Selection Decision

By Ron Cohen, CPA, MST
Partner
Greenstein, Rogoff, Olsen & Co., LLP
Posted: 12/13/2011

This comes up very often. How do we decide on whether to be a “C” Corporation or an “S” Corporation? You might also want to operate as a Limited Liability Company which is much like an S Corporation.

This is a description of the nightmare scenario with C corporations:

Which leads to the downside of selling assets in a C corporation, there are no favorable capital gains rates for C corporations. Thus, a corporation selling appreciated assets, even if a capital gain is generated, will pay corporate level tax at the marginal corporate rate, which quickly reaches 34% (35% for income in excess of $10 million). If the cash is then distributed in liquidation, the shareholder(s) will have another taxable event measured by the amounts received in liquidation less the tax basis in the shares. (From Ron: at an additional 15% under current federal law of the after-corporate tax dividend.) This second level of tax on corporate distributions is why C corporations are said to be “double taxed”. State taxes must also be considered.

Often, the Buyer of a company will refuse to purchase the stock of your corporation because they don’t want to acquire any undisclosed corporate liabilities. So the Buyer will demand you sell the corporation’s assets, not stock.

With an S Corporation, there is only one level of tax, at the shareholder level, which is currently at a 15% long-term capital gains tax rate.

Example with a C Corp:

$1,000,000 gain on sale of Intellectual Property Assets by C Corp.

$1,000,000
- 340,000 (Tax at 34%) Federal
- 60,000 (Tax at 6.0% effective rate for California after federal deduction for state tax)
$ 600,000 After corporate tax cash distributed to shareholder in liquidation of C Corp.
- 126,000 Tax on shareholder on dividend (15% Federal and effectively 6% for California)
$ 474,000 Remaining cash after all federal taxes.

Total Tax: $526,000 = to 52.6% tax rate.

Example with an S Corp.:

$1,000,000 (No corporate level federal Tax)
-$ 15,000 (California S Corp tax of 1.5%)
$ 985,000 After Corporate Tax Cash to Shareholder
-$ 206,850 (15% Federal and about effectively 6% California Tax to Shareholder)
$ 778,150 Net Final after tax cash to the shareholder.

Total Tax: $221,850 = to 22.18% tax rate.

“C” Corp tax greater than S corp Tax: $526,000 -$221,850 = $304,150 Tax Savings on a $1m gain… Missing this is a tragic tax planning mistake.

Sometimes, to a limited extent, this can be fixed by paying a big bonus to the shareholder out of the “C” corp that is only taxed once…but that is a last resort and the IRS won’t let the bonus be too big.

Moral: Try never to put appreciating assets in a “C” corp.

Sometimes you have to be a “C” corporation because you plan on going “public” soon, but otherwise, a “C” corporation is to be avoided lacking another very good reason.

Please give us a call if you have any questions or comments.