by Gregory S. Dowell
February 19, 2020
One of the more dramatic provisions of the Tax Cuts and Jobs Act (TCJA) was the reduction of the overall corporate tax rate to 21%. For a quick backdrop, there are effectively two kinds of corporations for federal income tax purposes. All corporations start out as regular run-of-the-mill corporations – let’s call those “C corporations”. A special provision in the Internal Revenue Code allows certain corporations who meet strict criteria to become a “small business corporation”, commonly called the S corporation. C corps who qualify under the criteria can elect to be S corps – thus giving us the two different kinds of corporations, the C corps and S corps.
Because of the benefits of being an S corp, most C corps that could qualify for this status elected to be S corps. Because of a limitation on the number of shareholders, many people assume that S corps are smaller businesses, maybe just a cut above mom-and-pop shops. That is a bad assumption, however. There are some very, very large corporations that have few shareholders and have elected S corp status – so S corps are not necessarily limited to just smaller businesses. Historically, because of the advantages of being an S corp, those businesses that remained C corps were those businesses that had many shareholders (like publicly-traded corporations) and certain other businesses where it was deemed to be strategic to remain a C corp.
Initially, many thought TCJA might dramatically change the landscape for smaller businesses when the highest corporate tax rate was reduced to 21%. While many new C corps were formed as a result of TCJA, in practice we have not seen a mad rush to be a C corp. Largely, that’s because the age-old problem of double-taxation in a C corp still exists, even though it’s less of a problem now with the lower cap of 21%.
Given the interest in C corps, however, it is worth taking a look at some of the basic characteristics of the entity. The following will cover some tax and nontax matters relative to a C corp:
- A C corporation is a corporate entity (either U.S. or non-U.S.). If a U.S. corporation, it is organized at the state level and under state law, not the federal level. A corporation comes into being when its organizers file articles of incorporation with a state (or a country, in the case of a foreign corporation). Ownership of a corporation is in the form of stock, and there is no limit to the number of shareholders that can own a single C corporation. In addition, there is no limit on the number of classes of stock that can be issued.
- Assets and liabilities: A corporation owns its assets and is liable for its debts. Assuming the corporation has been operating as a separate entity and has respected its corporate identity, shareholders are not liable for corporate debt. The fact that the shareholders are not liable for corporation debt is one of the primary advantages of the corporation as a form or doing business.
- Management and employees: The C corporation is managed by its employees, who are hired by the corporation’s board of directors. The members of the board of directors are elected by shareholders. The shareholders do not have a right to directly manage the affairs of the C corporation. Instead, they exercise indirect control over the corporation by electing the board, which then appoints corporate managers.
- Shareholders who provide services to a C corporation are treated either as employees or independent contractors, depending on the specific circumstances, and are taxable on compensation received. When shareholders are employees of a C corporation they are eligible to receive tax-free fringe benefits, such as health care benefits. They can also participate in company-sponsored retirement plans.
- Taxation of a C corporation: A C corporation is taxable on the income it earns. Shareholders of a C corporation are not directly taxable on this income. A C corporation is the only business form where this is the case. All other forms of business are pass-through entities, where owners are taxed directly on entity-level income.
- Although shareholders are not taxed directly on corporation income, they can be indirectly taxable on the income. If a C corporation distributes the income in the form of dividends, then the shareholders pay tax.
- Transfers of assets and liabilities to a C corporation: When a C corporation is formed shareholders contribute cash, property, or services to the corporation in exchange for stock; and sometimes the corporation assumes shareholder liabilities (such as debt to which property is subject). Contributions of property and debt in exchange for stock are usually tax-free; however, there are exceptions. When the corporation assumes debt, and the debt exceeds the basis of property transferred in exchange for stock, then the excess debt triggers gain recognition. In addition, transfers of appreciated property to a corporation in exchange for its stock are tax-free only if the transferors of property own at least 80% of the corporation after the transfer.
- When stock is received in exchange for services provided to a C corporation, the receipt of stock is usually taxable.
- Distributions of property to shareholders: Although the transfer of property to a C corporation is tax-free, the distribution of appreciated property by a corporation to a shareholder is usually taxed. When appreciated property is distributed by a C corporation to a shareholder, either as a dividend or as consideration for the repurchase of stock, the corporation ordinarily recognizes gain as if it sold the property to the shareholder; and, the shareholder recognizes gain equal to the excess of the value of the property received over the shareholder’s stock basis.
- Estate planning: The C corporation is a useful device for minimizing estate and gift tax. In general, stock in a C corporation is often valued (for estate and gift tax purposes) at a discount to the value of assets owned by the corporation.
This is just a brief overview, but provides a look at some of the basic characteristics of a C corporation. When choosing an entity type for a business, it is important to take into consideration as many factors as possible. Even if there is no single perfect choice, careful consideration will narrow down the list and ultimately lead to the best possible entity type.