Three Reasons to Be a C Corporation

When businesses start up, one in three operates as sole proprietorship; most of the others form limited liability companies or S corporations. Practically no businesses start out as C corporations, but maybe they should. Business owners may be overlooking opportunities in being a regular, C corporation.

Raising capital
There is a special tax rule that benefits investors of certain C corporations. It allows them to pay no tax on gain from the sale of “qualified small business stock” (QSBS) if they hold the stock for more than five years. So, being a C corporation may help to raise capital.

To qualify for the 100% exclusion, all of the following rules must be met:

  • The stock must be acquired after September 27, 2010, and before January 1, 2011.
  • The corporation must be an operating business (not a holding company or hedge fund).
  • The corporation cannot be involved in certain service businesses and professional activities (such as law or medicine), financial services, banking, farming, the extraction of natural resources, and the operation of hotels, motels, restaurants or other similar businesses.
  • The gross assets of the corporation cannot exceed $50 million.
  • The stock must be acquired by noncorporate taxpayers -- individuals and pass-through entities such as partnerships, S corporations, and trusts --  directly from the corporation or from an underwriter.

Thus, a C corporation may be a good idea for tech companies, manufacturers, and retailers that can meet “qualified small business” criteria. QSBS can be used to raise financing for the business. It can also be used for compensation to valued employees (QSBS can be acquired in exchange for services).

Medical reimbursement plans
Businesses of any type can use a variety of arrangements for medical assistance to employees, including flexible spending accounts (FSAs), health savings accounts (HSAs), and health reimbursement arrangements (HRAs). However, only C corporations can offer employees a medical reimbursement plan (a “Section 105 plan”). This arrangement will cover a set dollar amount of health expenses of employees. The plan must be nondiscriminatory, but can cover owner-employees without restriction.

For example, say a one-person company is a C corporation with a medical reimbursement plan. The plan offers reimbursements up to $5,000 of uninsured medical costs for the owner-employee, as well as his/her spouse and dependent(s). As long as the language of the plan provides comparable coverage for all employees, the owner-employee is not taxed on the reimbursements while the corporation deducts them.

Lower taxes
Congress currently is debating a reduction in the corporate tax rate. The U.S. now has the highest corporate rate among developed countries throughout the world. Japan’s rate, which had been 39.5%, dropped its rate on April 1 by 4.5%, bringing it well below the U.S.’s rate of 39.2% (combined federal and state rates). The U.K. also dropped its rate on April 1 from 28% to 27% in a multi-year rate decrease that will reach 24% in 2014. The average rate for countries in the Organization of Economic Cooperation and Development (other than the U.S.) is 25.5%. The Tax Foundation has a chart of rates.

In the State of the Union address, President Obama called for a reduction in the 35% corporate rate, which has been the rate since 1993.

Various proposals in Congress have suggested a reduction in the top rate to as low as 24% or so. The House Ways and Means Committee is holding hearings today on corporate tax reform in the context of a global market.

There has been no corresponding suggestion for a reduction in the top individual tax rate, which is 35% through 2012. If President Obama has his way, this rate will rise to 39.6% in 2013. Thus, owners of C corporations would be in a position to shelter corporate earnings and eventually withdraw them at favorable capital gains rates by selling shares; owners of other entities would likely be at a tax disadvantage.

Bottom line
Business owners should review their entity options with a knowledgeable tax practitioner, considering not only the factors I’ve discussed, but state tax issues, also.

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