In our last article we did a deep dive into C-Corps and the many, many downsides they have compared to S-Corps. But we also noted there are some limited circumstances where utilizing C-Corps can make sense.
So what do those scenarios look like?
For this strategy to work, there are a few key parameters you need to be able to satisfy:
- You need to be a very high earner
- You need to have the ability to not distribute earnings from your C-Corp for a very long time
- Ideally, you live in a no-income-tax state. This strategy can still work if you don’t, but the payback period becomes longer
C-Corp Double Taxation
As we noted in the last article, one of the main issues with the “guru” math is that it completely ignores both the taxation on distributions and the progressive/tiered income tax the US has for personal taxes. For a client making $1 million, they will talk about the 37% top individual tax rate vs. 21% the corporate tax rate and stop there – making it sound like the client is paying $370k with an S-Corp and just 21% with a C-Corp.
But that’s not the case. For taxpayer (filing as single) making $1 million, here is what the federal income tax bill would look like:
| $1M Profit | ||
| C-Corp | S-Corp | |
| Income Taxes | $210,000 | $272,000 |
That’s a savings of closer to $60k, not $160k. But even that still sounds pretty good. It seems like free money – so why wouldn’t you do it?
Because it completely ignores the tax paid on distributions. Once you factor those in, it looks like this:
| $1M Profit | ||
| C-Corp | S-Corp | |
| Income Taxes | $210,000 | $272,000 |
| Tax on Distributions | $197,000 | $0 |
| Social Security/Medicare | $0 | $31,000 |
| Total Taxes Paid | $407,000 | $302,000 |
Even factoring in over $30k of payroll taxes (since you are required to pay yourself a reasonable salary with an S-Corp), a properly optimized S-Corp saves you over $100k.
The C-Corp on its own fails pretty miserably.
So when does it work?
Hybrid S-Corp and C-Corp Strategy
Where the C-Corp can make sense is in conjunction with an S-Corp. This is a strategy we initially started exploring with clients when they were looking at setting up a second or third company and did not need the cashflow from that entity. They did not need or want to take distributions for a very long time, so the double taxation became less of a factor.
Imagine the taxpayer is making that same $1 million, but is earning it through two separate companies – each earning $500k. What does that tax liability look like?
| $1M Profit – $500k C-Corp/$500k S-Corp | ||
| C-Corp | S-Corp | |
| Federal Income Taxes | $105,000 | $116,000 |
| Tax on Distributions | $77,000 | $0 |
| Social Security/Medicare | $0 | $23,000 |
| Total Taxes Paid | $182,000 | $139,000 |
That’s a combined tax burden of about $321k. But the $1 million S-Corp on its own only had a liability of $302k. So why would you go through the headache and additional administrative burden of two companies and cost yourself $19k in the process?
Because of the distributions. If you are able to avoid the distributions, the tax looks like this:
| $1M Profit – $500k C-Corp/$500k S-Corp | ||
| C-Corp | S-Corp | |
| Federal Income Taxes | $105,000 | $116,000 |
| Tax on Distributions | $0 | $0 |
| Social Security/Medicare | $0 | $23,000 |
| Total Taxes Paid | $105,000 | $139,000 |
That’s a total of $244k, giving you a savings of $58k compared to the S-Corp. Eventually you still have to distribute those funds and pay the tax. But in the immediate term, that liability is deferred.
Let’s say you take that $58k and invest it into the market and earn 8% per year. (Not an unrealistic expectation since the long-term average annual return in the stock market is 9-10%.) By Year 15 it will have grown to nearly $185k. Even after you pay the $77k (the tax you deferred 15 years earlier by not distributing the C-Corp funds) and factor in the $19k lost by not going S-Corp from the start, that’s still about $90k of left over funds.
That’s not inconsequential. Which is why it’s a strategy we discuss with clients – especially those who are earning even more than that. The benefit of the strategy really becomes more apparent for entrepreneurs earning multiple millions.
Significant Downsides to Consider
But it’s not without its downsides and other factors to consider.
First, this person’s money had to be held captive within the C-Corp for fifteen years. If something unexpected had come up – like a family emergency, business setback, or investment opportunity that required that they distribute the money in Year 5, the math completely blows up.
Second, this strategy becomes more difficult to justify if you are in a state with an income tax – especially if you are in a state with a high-income tax. All of the figures above only factor in federal taxes. If you live in a state with income tax, the C-Corp strategy doubles state taxes on pay on any income associated with the C-Corp – first when earned and again when distributed.
Let’s say you live in Virginia and did the $500k/$500k split example above. On the C-Corp side of things, you will eventually pay nearly $60k vs. the $30k on the S-Corp side. Those taxes are eating up a significant amount of your savings and will require you to hold the assets in the C-Corp even longer in order to justify the maneuver.
Third, it does require significant amounts of income to at all make sense. $500k (which is over 6x the median household income) is almost the minimum required for it to make any sense. Here’s what that would look like in all three scenarios (same as before this is for a single taxpayer):
| $500k Profit | ||
| C-Corp | S-Corp | |
| Income Taxes | $105,000 | $116,000 |
| Tax on Distributions | $77,000 | $0 |
| Social Security/Medicare | $0 | $23,000 |
| Total Taxes Paid | $182,000 | $139,000 |
| $500k Profit – $250k C-Corp/$250k S-Corp | ||
| C-Corp | S-Corp | |
| Federal Income Taxes | $53,000 | $42,000 |
| Tax on Distributions | $30,000 | $0 |
| Social Security/Medicare | $0 | $11,000 |
| Total Taxes Paid | $83,000 | $53,000 |
The combined tax liability splitting the income between an S-Corp and C-Corp is about $136k. That’s marginally lower than it all being earned in an S-Corp, but this taxpayer also did not contribute anything to Social Security. And if you defer the tax on the distributions that’s another $30,000 you have available to invest.
But anything much lower than that and the math doesn’t work. Even for married taxpayers (since they have more favorable tax brackets) the math may not work and could require higher profit levels. It would depend on if your spouse works and what other sources of income you have.
And lastly, there is an administrative burden associated with this. You have to file multiple tax returns, have multiple insurance policies, possibly run payroll for two different companies, etc. It can be a lot of additional headaches. So the tax savings must be substantial to justify the effort.
Conclusion
Put simply, it’s just not a fit for most people. But for the right fit? It can be a very powerful strategy.
So, if it is a fit for you, how would you implement it? What are the pitfalls to avoid? That is exactly what we’ll explore in the next article.
Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
