Shareholders in a corporation must consider several important factors when deciding if they want their entity to be taxed as a C Corporation or as an S Corporation. Both structures have distinct tax advantages. Ultimately, each company will need to look at the key differences to decide what is best for their organization. The differences highlighted in this article relate to the taxation of income, planned distributions and deductibility of losses.
Taxation of Income
All income that is generated in the current year is only taxed once for both C Corporations and S Corporations. A C Corporation’s income is taxed at the entity level at the current flat rate of 21% for federal purposes. An S Corporation’s income flows through to the shareholder and is taxed at the shareholder’s marginal rate. Taxation at the state level also differs between the two entity types and should be considered during the decision-making process.
Planned Distributions
Where the double taxation of C Corporations comes into effect is when shareholders take distributions from the company. This is another significant difference between C and S Corporations.
In an S Corporation, if shareholders receive a distribution of capital that is not in excess of their basis, the distribution will be considered a nontaxable return of capital and will not be included in the shareholder’s individual income. This is because the income that the entity generated was already taxed on the shareholder’s individual return.
However, with a C Corporation, that same distribution will be considered a dividend to the shareholder, to the extent it is paid from corporate earnings, and will be included in the individual’s taxable income, just as if the shareholder received a dividend from an investment portfolio. If the payment exceeds the corporate earnings, it will be considered a return of capital, reducing the shareholder’s basis in the investment with any excess being taxed as a capital gain.
If shareholders plan to take significant yearly distributions, they will see a greater tax savings by electing S Status. However, if shareholders plan to reinvest a large portion of the earnings back into the company, take minimal distributions, and are in a tax bracket that is higher than the combined federal and state corporate rates, then they will likely see greater tax savings by remaining a C Corporation.
It is important to note that C Corporations must be mindful of their retained earnings and not let them accumulate too long without making distributions or reinvesting in the business, because the IRS can levy the Accumulated Earnings Tax. This tax is a penalty that the IRS can impose when they deem C Corporations are retaining their earnings beyond their reasonable business needs in order to avoid the double taxation that occurs when the company pays dividends.
Deductibility of Losses
Avoiding double taxation is the biggest benefit of electing S status if the company generates income, but what if it is generating losses?
In an S Corporation, the losses will flow through to the shareholders, just the same as income flows to them. This can be beneficial to the shareholder because they may be able to deduct the entire business’ loss on their individual tax return, as long as they are not subject to any passive loss limitations or the loss is not in excess of their basis in the company. If the shareholder materially participates in the company, they will be able to utilize the company’s loss to offset any of their income, and if they are a passive shareholder they can use it to offset any of their passive income. This could result in a significant reduction of taxable income for the year of the loss. Additionally, since the losses are reducing the shareholder’s taxable income, this can also result in the shareholder being taxed at a lower rate than if the loss had not been passed through to them. So not only can a loss passed through from an S Corporation reduce the shareholder’s taxable income, thus reducing their tax, the income that remains after the loss has been applied could be taxed at lower marginal rate.
This benefit would not apply if the company is a C Corporation as the loss will remain at the entity level. The C Corporation will be able to utilize the Net Operating Loss in future years, but it will only offset income that the company generates since it stays at the entity level. Shareholders will not be able to utilize the loss to offset income they receive from other sources as they could if the company were an S Corporation.
Conclusion
In summary, there are distinct benefits to both electing S Status as well as remaining a C Corporation, with specific differences related to the taxation of income, planned distributions and deductibility of losses. A company’s specific circumstances will determine which status makes the most sense for them. We would be happy to offer guidance for any company that is considering making a change in entity status. Feel free to contact your H2R CPA liaison and they will be happy to assist you with any questions.
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