The Tax Cuts and Jobs Act provides a flat 21% federal income-tax rate for C corporations. This is great news for these entities and their owners. But some fundamental tax truths remain for C corporations.
C corporations are subject to double taxation. Double taxation occurs when corporate income is taxed once at the corporate level and again at the shareholder level when dividends are paid. The cost of double taxation is generally less new because of the 21% corporate rate.
Double taxation is not a problem when a C corporation retains all its earnings to finance growth and capital investments. Because earnings stay “inside” the corporation, no dividends are paid to shareholders and double taxation does not occur.
Likewise, double taxation is not an issue when a C corporation’s taxable income levels are low. This often can be achieved by paying reasonable salaries and bonuses to shareholder-employees and providing them tax-favored fringe benefits, which are deductible by the corporation and tax-free to the recipient shareholder-employees.
C corporation status generally isn’t advisable for ventures with appreciating assets or certain depreciable assets. If assets like real estate eventually are sold for substantial gains, it may be impossible to extract profits from the corporation without being subject to double taxation. In contrast, if appreciating assets are held by a pass-through entity — such as an S corporation, partnership or limited liability company treated as a partnership for tax purposes — gains on such sales are taxed once, at the owner level.
But assets held by a C corporation don’t necessarily have to appreciate in value for double taxation to occur. Depreciation lowers the property’s tax basis, so a taxable gain results whenever the sale price exceeds the depreciated basis. In effect, appreciation can be caused by depreciation when depreciable assets hold their value.
To avoid this double-taxation issue, you might consider using a pass-through entity to lease to your C corporation appreciating assets or depreciable assets that will hold their value.
C corporation status generally isn’t advisable for ventures that will incur ongoing tax losses. When a venture is set up as a C corporation, losses aren’t passed through to the owners (i.e., shareholders) in the same way as a pass-through entity. Instead, they create corporate net operating losses (NOLs) that can be carried over to future tax years and used to offset any corporate taxable income.
This was already a potential downside of C corporations, because it can take many years for a startup to be profitable. Now, under the TCJA, NOLs that arise in tax years beginning after 2017 can’t offset more than 80% of taxable income in the carryover year. So it may take even longer to fully absorb tax losses.
Do you have questions about C corporation tax issues in the TCJA era? Contact us!