As a new business owner, your first major decision is how to structure your business. Choosing the wrong business structure can have major financial ramifications, both during the operation of your business and when it comes time to sell. Read on to find out why most business owners will regret being a C corp—and why you should seriously consider structuring as an S corp instead.
What Is a C Corp?
“C corporation” is a term used to describe corporations that are required to file taxes under Subchapter C of the Internal Revenue Code (IRC). When you form a corporation, your business is automatically required to file taxes as a C corp.
C corps are beneficial for owners who desire no limits on foreign ownership or fewer limitations on issuing stock. Most publicly traded companies are registered C corps for two reasons: flexibility of ownership and ability to raise capital. While large companies may find that a C corp’s benefits outweigh its drawbacks, most privately owned business owners would beg to differ.
Four Major Disadvantages of a C Corp
Reason #1: You will be taxed double on income.
The primary drawback of owning a C corp is the tax treatment. First, as a C corp, you are required to pay federal income taxes at the corporate rate—currently 21%. Second, any distributions you make from your company will then be taxed at the personal level. The current dividend tax rate ranges from 0% to 20% for qualified dividends, and from 10% to 37% for non-qualified dividends.
Some C corp owners try to get around double taxation by taking larger salaries and running personal expenses through the business. But if you are then subjected to an IRS audit, this can become very problematic.
Meanwhile, “pass-through” entities—such as LLCs, LPs, and corporations classified under subchapter S of the IRC (known as “S corporations”)—pass income and losses directly to the owner. This means, as the S corp owner, you bypass the 21% corporate tax and pay only personal income taxes on your business profits. Additionally, certain pass-through entities may benefit from a tax deduction of up to 20% of their qualified business income.
Reason #2: You will be allowed no personal write-offs for business losses.
C corp owners are not permitted to write off business losses on personal tax returns. This is especially important if you are a business owner with multiple streams of income. Say your business lost $500,000 last year but your other income streams total $750,000 in taxable income. If your business is classified as a C corp, you will need to pay taxes on the entire $750,000. But if your business is classified instead as a pass-through entity, you will net the $500,000 loss against your $750,000 personal income—in other words, your new taxable income will be only $250,000.
Perhaps now you are starting to see why you shouldn’t register your business as a C corp.
Reason #3: You will receive less in proceeds.
When you sell your business—whether that time is near or far off in the future—the transaction will be structured either as an asset sale or a stock sale. Potential buyers typically prefer an asset sale in order to avoid certain liabilities, known or unknown, that your business carries. Someone looking to buy your business also will receive tax benefits from an asset sale, by marking up the value of certain assets and recognizing more depreciation to offset business income. C corps, on the other hand, are double taxed in asset sales.
C corp proceeds from an asset sale are first paid to the corporate entity, where corporate capital gains taxes are paid on the value of the assets being sold over the assets’ book value. Capital gains for fixed assets are taxed at ordinary income levels, so the same tax rates discussed earlier will apply to your proceeds in an asset sale. S corps and other pass-through entities are not subject to taxes at the corporate level.
Reason #4: You will be less appealing to buyers.
Unlike a potential buyer, a C corp owner will almost always seek a stock sale in order to bypass corporate taxes altogether. Stock sales are typically less advantageous to buyers, who may experience tax disadvantages because they must assume the basis of your asset’s depreciation at the time of sale. Down the road, this will result in higher taxes for the buyer than an asset sale would. In a stock sale, a buyer assumes all your company’s liabilities, known or unknown, unless specified in the purchase agreement. These factors may persuade the buyer to discount your purchase price due to the additional taxes and liabilities they are assuming from the stock transaction.
Making the S Corp Conversion
If you already started your business as a C corp, you may be wondering how to switch to a more advantageous business structure. It’s possible for some C corps to convert to the S corp structure and thus avoid double taxation by electing to be taxed as a pass-through entity. Although the conversion may require some upfront work, it can save you from many of the downsides that can occur later.
Converting to an S corp is not difficult, but determining whether you should apply for conversion does require some analysis. Does it truly make sense for your business?
One of the most important factors to consider is the built-in gains (BIG) tax—that is, tax on the amount of appreciation related to an asset owned by your corporation, including intangible assets such as “goodwill.” The S corp conversion triggers a need to determine whether the BIG tax applies and to what extent. If you sell your company within five years of conversion from a C corp to an S corp, tax will be due (at the C corp income tax rate) on the BIG amount from the time of incorporation to the time of conversion. With proper planning, the effects of a BIG tax may be avoidable. Still, understanding this potential tax liability is essential as you consider conversion. Be sure to explore all considerations of converting to an S corp with the proper legal and tax advisors before making a switch.
If you are a C corp owner looking to sell your business, and you want to benefit from S corp taxes, planning ahead is crucial. Running a C corp can mean a significant tax burden on your income, both now and when you decide to sell. Thankfully, you have options to structure a transaction that will maximize your proceeds, regardless of your business status. By seeking out the right advisors, you can ensure that you’ll recognize the maximum value from your business.