C-corps are a dying breed of tax structure these days for small businesses. That’s mostly due to their inefficiency when it comes to strategy and planning. This article will explain how entity restructuring a c-corp business can significantly impact your bottom line.
Business Tax Structure Options
You have several options when it comes to how your business is structured for tax purposes. Pass-through entities, like LLCs or subchapter S-corporations (S-corps), afford business owners many more opportunities not available in the traditional C-corporation (C-corp) structure.
S-corps and LLCs do not pay corporate taxes at the federal level. Instead, the profit from the business passes or flows through to the owners who pay the tax. Alternatively, C-corps pay tax at the corporate level, and then again when the Owner takes a draw from the business.
Avoiding Double Taxation with Business Tax Structure Entities
Who wants to pay taxes twice? To avoid double taxation, C-corps only have one planning option. If you are a C-corp, you know the strategy well. You adjust owner compensation at the end of the year based on projected profit.
To reduce profit and the corporate tax associated with it, the strategy is to increase the Owner’s W2, typically, with a bonus. There are two significant issues with this strategy in light of better available options.
First, all W2 compensation is subject to employment taxes, which can be up to 15.3 percent. The employer pays half, and the employee, the other half. As an owner, let’s just say you pay both. Ouch.
Second, there is a 20 percent deduction on certain business income (QBI) only available for pass-through entities, which you aren’t going to receive through your W2 or bonus compensation. This 20 percent deduction effectively reduces your tax rate by 20 percent for that income.
So, if you’re in a 35 percent tax bracket, your savings with this deduction would be 7 percent on that income. Unfortunately, this common tax strategy is all you have at your disposal in the C-corp structure.
Restructure Your C-corp Entity to a Pass-through Entity
Pass-through entities are the way to go. If you were to make a simple election to be treated as an LLC or S-corp, you could open up many planning opportunities. Specifically, you can look at the nature of how you are taking income and adjust it for the optimal tax treatment.
For example, let’s say you’re 100 percent Owner of X Company, a C-corp. At the end of each year in December, you and your CPA project the business profit, and you give yourself a bonus.
Your total compensation for 2020 was $500,000, all through payroll. You successfully avoid double taxation at the C-corp level, which is showing a break-even. You pay about $32k in employment taxes and, assuming the highest tax bracket, $185k in federal income taxes.
You decide to elect to be treated as an S-corp for tax purposes. This allows you flexibility in determining how you receive your income, AKA the nature of your income.
You can receive W2 compensation, subject to employment taxes, or you can take out distributions that are not subject to employment taxes and get the benefit of the 20 percent income deduction for pass-through entities.
You decide to pay yourself a reasonable W2 compensation ($150,000) and take the rest out as a distribution. The distribution gets the 20 percent QBI deduction and is not subject to employment taxes. This simple change would net annual tax savings of $35,000+ for this business owner.
Restructuring a C-corp Entity: Key Takeaways
For multiple shareholders active in a business, you could look at the nature of everyone’s compensation. Bottom line, a simple election out of your C-corp structure can net huge annual tax benefits. It can also offer flexibility and tax benefits to those planning an exit within the next few years.
At C&A, our tax and organizational consultants have helped many businesses look into the benefits of restructuring. Contact us today for a free consultation on how you can save on your business taxes and keep more of your hard-earned money.