When used correctly, C Corporations are a great way to supercharge a tax strategy. I find that when my clients make the most of their C Corporations, they reduce their taxes by a minimum of $10,000 every year.
– The Biggest Mistake With C Corporations –
The key to saving $10,000 in taxes every year is knowing how to use a C Corporation correctly. When I meet with prospects and review their prior year tax returns, it’s not unusual that I find a C Corporation that isn’t being used correctly. In these cases, the C Corporation is not saving any taxes and in some cases it is actually creating more taxes! So what makes these C Corporations not work? These C Corporations do not save taxes because the wrong type of business is in the C Corporation.
Only certain types of businesses will generate tax savings by operating as a C Corporation. The type of business that does work is what I refer to as a support business or a secondary business. Now, you may be wondering, what is a support or a secondary business? Sometimes it’s easier to define what it isn’t.
The Types of Businesses That Don’t Save Taxes in a C Corporation:
Primary Operating Business. This is a business that creates the main source of cash flow for the owner. The owner relies on this cash flow for living and other personal expenses. The primary operating business is how the owner makes a living. In this type of business, it is critical that the owner be able to get cash out of the company in a very tax efficient way. While it is possible to get cash out of a C Corporation, it becomes inefficient from a tax standpoint to do so with large amounts of cash. Bottom line: if you rely on the cash from your business to pay for your living expenses, that business is not ideal for a C Corporation.
Investment or Rental Real Estate Business. There are several reasons why this type of business doesn’t work in a C Corporation. I’ll share the top two reasons.
First, this type of business involves assets that appreciate. C Corporations do not have a “special” lower tax rate for capital gains (which are generated from appreciated assets). Individuals do have a special capital gains rate so that benefit is completely lost in a C Corporation.
Second, the income generated from these investments is often subject to a special (additional) tax in C Corporations called a personal holding company tax. This tax only applies to this type of income and only in a C Corporation. The tax effectively eliminates the lower tax rates that a C Corporation normally has. This tax was specifically put in place to keep taxpayers from putting investment assets in a C Corporation as a way to pay less tax on their investment income.
The Type of Business That DOES Save Taxes in a C Corporation:
Now that we have eliminated primary operating businesses and investment businesses from the types of businesses that do not save taxes in a C Corporation, what is left? What is left is secondary or support businesses. These are best defined as businesses that generate a modest amount of profit (no more than $75,000 annually) and the cash flow that is generated is not needed by the owner to pay for living or personal expenses.
By far the biggest objection I hear anytime I bring up a C Corporation is…
But What About the Double Tax? Sometimes just the mere thought of paying a double tax sends people running in fear. Fortunately, I’m not afraid of the double tax and I actually have a strategy where the double tax can work to reduce my clients’ taxes.
What Is the Double Tax? The double tax is this:
First tax: A C Corporation pays its own tax on its net income. This is the first tax.
This is a great tax reduction strategy! Because a C Corporation pays its own tax, it has its own tax rules and you can legally use these rules to reduce your taxes.
Second tax: A C Corporation can use the cash it has after paying its own tax to pay dividends to its owners. When a C Corporation pays dividends to its owners, the owners pay tax on that dividend. This is the second tax.
At first glance, which is usually the only look most people (including CPAs) give a C Corporation, it seems that the double tax is the worst case scenario when it comes to tax planning. So many are surprised when I share this:
It Is Possible to Pay Less in Tax Even With a Double Tax!
Let’s take a look at how the C Corporation double tax can play out:
First tax = 15% A C Corporation pays 15% tax if it has net income of $50,000 or less.
Second tax = 15% An individual pays 15% tax on dividends.
Total double tax = 30% (The double tax can end up being a little less than 30% but to keep things simple for this example, 30% will be used).