One decision that almost every business should revisit from time to time is whether its current organizational structure is meeting its needs. The difference between personal and business tax rates is just one factor that may influence that decision.
Federal tax rate increases in 2013 could affect some of the 30 million business owners who include business profits on their personal income tax returns.1 The top individual tax rate, which affects single filers with taxable incomes exceeding $400,000 and joint filers with incomes exceeding $450,000, rose to 39.6% in 2013 from 35% in 2012. For comparison’s sake, the top corporate tax rate remained unchanged at 35%.2
Corporations are separate legal entities from their owners, which is why shareholders generally cannot be held liable for S and C corp debts.
Tax Treatment
Both S and C corporations must file annual tax returns, but they are taxed very differently. S corp profits and losses are “passed through” to the owners, who are taxed at personal income tax rates, even if profits are later reinvested in the business to pay for new employees or equipment.
C corporations could be subject to corporate income tax at both the federal and state levels, but they may be able to deduct the salaries and bonuses of owners and employees as business expenses. Initial corporate income tax rates may be lower in some cases than those paid by individual owners, who might benefit by allowing the business to retain some of the profits.
Any dividends distributed to C corp shareholders are paid from the corporation’s after-tax profits and are taxable to the recipients, creating the potential for double taxation.
Ready to Grow, or Sell
Larger and fast-growing companies are commonly organized as C corps because this business structure allows for multiple classes of stock and an unrestricted number of shareholders. S corps, on the other hand, are limited to one class of stock and no more than 100 shareholders.
A company that switches from an S to a C corp must remain a C corp for at least five years.3 This may be a key consideration for owners who anticipate a sale in the near future, because the double taxation situation may also apply when a business is sold.
1–3) The Wall Street Journal, February 20, 2013
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