A small business can easily avoid double tax and retain all-important liability protection either by incorporating under state law and adopting subchapter S status for federal tax purposes or by forming a limited liability company under state law and filing as a partnership. So shouldn't every right-thinking small business owner avoid the double tax on corporate profits?
Apparently not. According to a new study from economists at the Treasury Department, more than 1.6 million small businesses are subchapter C corporations (Matthew Knittel, Susan Nelson, Jason DeBacker, John Kitchen, James Pearce, and Richard Prisinzano, "Methodology to Identify Small Businesses and Their Owners," Office of Tax Analysis, Technical Paper 4, Aug. 2011.)
Despite the corporate tax's bad reputation, there are good tax reasons for small businesses to subject themselves to double tax under subchapter C. After summarizing the available data on small C corporations, this article calculates the tax benefits of subchapter C status for a typical small business. 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.
Focus on Small Business
The new study from Treasury economists provides a wealth of data on small business. As you might expect, the bulk of the analysis focuses on passthrough businesses -- sole proprietorships, partnerships (including LLCs), and S corporations. But C corporations are very much a part of the small business landscape. According to Treasury calculations, C corporations accounted for 23 percent of small business total receipts.
Table 1 summarizes the Treasury study's findings on C corporations. In 2007 there were 1.86 million subchapter C returns (Form 1120) filed. Of those, the study classified 1.64 million as filed by real businesses. (To be a business for purposes of the study, a corporation had to have at least $5,000 of deductions and other similar minimum measures of business activity.) Of those 1.64 million businesses, 1.56 million were classified as small businesses. (Small businesses had total receipts, or total income, of less than $10 million.) Of those 1.56 million, 864,000 were classified as employers. (Employers had wage and salary deductions in excess of $10,000.)
Graduated Corporate Rates
Why are so many small businesses volunteering to be subject to the corporate tax? Part of the answer is that the first $50,000 of corporate income is taxed at a 15 percent rate and the next $25,000 at a 25 percent rate. The official rate schedule is shown in Table 2.
Above $75,000 of corporate income, marginal tax rates are in the thirties. But as shown in the figure on p. 1325, the average tax rate (that is, total tax as a percentage of total profit) stays below 25 percent up to about $130,000 in profits and below 30 percent up to about $180,000. It is the expected average tax rate that is relevant when a business owner is deciding between subchapter C or passthrough status.
Table 3 gives us two glimpses of how many small C corporations take advantage of low graduated rates. In Panel A of the table, C corporations are classified by asset size. Corporations with between $1 and $500,000 of assets had $7 billion of taxable income and corporate tax (before credits) of $1.4 billion. Their average tax rate was 19.9 percent. Corporations with between $500,000 and $1 million of assets had an average tax rate of 24.5 percent.
Table 3. Tax Rates on Subchapter C Corporations in 2007
Source: IRS, Statistics of Income division. Data in Panel A are from the 2007
Corporate Source Book
(http://www.irs.gov/taxstats/article/0,,id=165716,00.html) derived by
subtracting Table 3 (S corporations) and Table 1 RIC and REIT data from
Table 1 (all corporations). Panel B data are from Table 22, "Returns of Active
Corporations, Other Than Forms 1120S, 1120-REIT, and 1120-RIC," of the 2007
Complete Corporate Report
Because it allows us to distinguish between taxpayers and non-taxpayers, Panel B provides a better vantage point on corporate tax paid by small business. In 2007 there were 463,000 C corporations that paid some tax but less than $10,000. These corporations on average had taxable profits of $15,300 and a tax rate of 16.3 percent. There were 45,000 C corporations that paid between $10,000 and $20,000 of corporate tax. These corporations on average had taxable profits of $86,700 and a tax rate of 22.9 percent. So there you have it -- a good half-million businesses paying corporate tax at rates in the high teens or the low twenties.
Although the corporate tax rate is low for small profits, it is still a second level of tax. To make subchapter C attractive to small business, there must be individual tax advantages for corporate income vis-à-vis passthrough income. There are two: the 15 percent rate on corporate dividends and the ability to defer individual tax on undistributed corporate earnings.
When considering choice of entity, a business owner must decide whether business earnings will be paid out as compensation or dividends -- and if they are paid out in dividends, if those dividends will be deferred. Then for each type of entity, the owner must calculate the effects of individual tax, payroll tax, and corporate tax. Table 4 does the math on the options for a business owner who has $50,000 of business earnings and has other sources of income that put him in the 35 percent bracket. (The calculations in Figure 4 draw heavily on the excellent article by Richard Winchester, "Working for Free: It Ought to Be Against the (Tax) Law," 76 Mississippi Law Journal 227 (2006).)
Sole proprietors and general partners must pay payroll tax on business earnings -- and so must limited partners and subchapter S shareholders for any compensation for services to the business. This adds $7,650 of tax, which is partially offset by the deduction of half that amount at the individual level. It is this extra payroll tax burden that is at the center of so many controversies as to whether LLC and subchapter S earnings are compensation or business profits.
The last three columns of Table 4 show the possibilities for a small C corporation. If a small business owner takes business earnings in the form of salary, he is even worse off than if salary were paid by a passthrough business. There may be no corporate income to take advantage of the deductible half of payroll tax (as assumed in Table 4), or if there are other corporate profits the payroll taxes would be deductible at the 15 percent corporate rate (instead of the 35 percent individual rate).
The much more relevant columns are the last two. A small corporation with $50,000 of earnings can pay a 15 percent corporate tax ($7,500) and then distribute after-tax earnings ($42,500) as dividends and pay 15 percent individual tax ($6,375). That's a total tax of $13,875 for a total tax rate on earnings of 28 percent. That compares favorably with LLC distributions or subchapter S income taxed at 35 percent ($17,500). The annual tax savings of choosing C over S status is $3,625.
But wait, there's more. While many small business owners need cash for living expenses and cannot afford to keep earnings in the business, there are some owners -- particularly those in high tax brackets with other sources of income -- who can allow the corporation to retain earnings. This deferral of individual tax can be thought of as a reduction in the individual dividend rate, where the size of the rate reduction depends on the length of deferral. For purposes of illustration, the last column assumes an effective dividend rate on deferred distributions of 10 percent (consistent with eight years of deferral, assuming a 5 percent discount rate). Under these assumptions, the total tax burden is $11,750, yielding an overall rate of 24 percent. The subchapter C small business owner pays $5,750 less tax than his subchapter S counterpart.
Under the right conditions, a C corporation can be a nice little tax shelter for a small business. That helps explain why so many small businesses remain C corporations when they have the option of becoming LLCs or S corporations.
Other Considerations for C Corporations
Fringe benefits (C corporation advantage). In general, the tax advantages for employee benefits are more generous for C corporations than for passthrough entities. The most notable of these advantages is the ability to establish a medical reimbursement plan. Since 2003 the insurance premiums of the self-employed have been deductible. But those premiums are subject to the 15.3 percent payroll tax. Out-of-pocket medical expenses are deductible only when they exceed 7.5 percent of adjusted gross income. Section 105 allows a C corporation to set up a medical reimbursement plan in which all medical expenses for employee-owners (and their families) are deductible against both payroll and profit taxes without including those benefits in the employee-owner's taxable income. This option is not available to employee-owners of passthroughs.
Treatment of losses (disadvantage). For businesses with losses, passthrough entities provide the advantage of allowing owners to deduct those losses on their individual returns. Losses of C corporations stay bottled up at the entity level. One provision of the law that reduces this disadvantage for small C corporations is section 1244. A corporation can issue up to $1 million of section 1244 stock. If that stock is sold at a loss, the losses are treated as ordinary business losses instead of tax-disadvantaged capital losses.
Personal service corporation (disadvantage). If a corporation is considered a personal service corporation (PSC), it cannot benefit from the graduated corporate rate structure. It pays a flat 35 percent tax on profits. A PSC is a corporation in which substantially all activities are personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. In addition, 95 percent of the stock is owned by employees, retirees, or their estates or heirs. With a little planning, avoiding PSC status is not difficult. For example, if the spouse of a small business owner owns 6 percent of the stock, and the spouse is not an employee of the business, the corporation is not a PSC.
Accumulated earnings tax (disadvantage). Deferral of small C corporation profits is limited by the accumulated earnings tax. It is an additional tax of 15 percent on accumulated taxable income in excess of $250,000 ($150,000 for PSCs) or in excess of an amount that meets the reasonable needs of the business.
Personal holding company tax (disadvantage). There are limits on the amount of investment income a small business owner can earn inside a C corporation in order to benefit from graduated corporate rates. A personal holding company is a C corporation with five or fewer individuals owning more than 50 percent of the corporation and with 60 percent or more of the profits from passive activities (personal holding company income). Personal holding companies are subject to an additional tax of 15 percent on any undistributed personal holding company income.
If the top individual tax rates rise above 35 percent, as proposed by President Obama and as scheduled under current law to occur at the end of 2012, the benefits of subchapter C status vis-à-vis passthroughs will increase. On the other hand, if the 15 percent dividend rate increases, the advantage of C corporation status will be cut.
And what about corporate rates? The most talked-about component of tax reform is a reduction of the top corporate rate. Would this entail a commensurate reduction in all rates in the corporate rate schedule (shown in Table 1)? Or, as some have proposed, should the corporate graduated rate structure be eliminated? The latter option is better economics. It would end the sheltering described above and result in more even taxation of business income. But it suffers from the severe political disability of imposing a tax increase on small business to pay for a tax cut on large business.
Finally, even this cursory overview of small business taxation makes clear that small businesses deserve a simpler tax system. The complexity and uncertainty facing small business owners about their tax situation is enough to squeeze the dynamism out of anybody's entrepreneurial spirit.