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Passthroughs still rule.
In recent years S corporations and other "passthrough" entities, such as limited liability companies, have become more popular than traditional C corporations. Rightly so. Passthroughs aren't taxed at the corporate level. Instead their earnings, losses and credits flow onto the owners' tax returns. C corps, by contrast, pay corporate income tax on the first dollar of earnings. If owners receive those profits as dividends, they're taxed again. For many reasons, we still believe the S corporation is King!
For C corps, since the maximum tax on dividends is chopped from 38.6% to 15%. Look closer. Passthrough entities did well, too. How so? Your earnings from a passthrough don't qualify for the 15% dividend rate; they're taxed at ordinary income rates, (in 2006 for the 2005 tax year) the lowest rate is 10% and the top rate is 35%. But the top C Corp. rate is 38%. And a double tax is still a double tax no matter what you call it -- the top combined corporate and individual tax on a dollar of distributed C Corp earnings is now 44.75%, compared with a 35% single rate for a passthrough.
Can't C Corp owners limit the double hit by taking large salaries and leaving less corporate profit to be taxed? Yes, but salary is subject to payroll taxes at a combined employer/employee rate of 15.3% on the first $87,000 in 2003 and 2.9% above that. With an S Corp you can take less salary and more profits, cutting payroll taxes. (Warning: Be reasonable. If you draw way too much or way too little salary, the IRS can challenge it.)
Consider a C Corp cash-out.
In the past many owners of C corps have retained earnings, rather than pay them out as dividends taxed at a 38.6% rate. That way, when they retired, they would be able to sell their generously capitalized business for more, thus effectively converting high- taxed dividends into low-taxed long-term capital gains. Even better, if they held the business until death, their heirs would get a "step up" in its basis, thus avoiding the gains tax, too.
But the new 15% rate for dividends provides a tempting opening to distribute some earnings.
Why not just leave all the cash in the company and defer taxes? Two reasons. First, under the new law the 15% rate, which applies to both dividends and capital gains, lasts only through 2008; in 2009 the top dividend rate returns to 35% and the gains rate to 20%. Second, if you accumulate too much in earnings in a C Corp, you could be hit with the accumulated earnings tax or the personal holding company tax. The new law drops the rates for these two penalty taxes from 38.6% to 15%, but again, only through 2008.
Don't act too fast, however. Companies must be careful not to become overly emotional about this and overdistribute dividends. Keep enough cash on hand to fund future operations. And before you distribute a penny, ask your tax accountant to calculate the impact on your state tax bill and your federal alternative minimum tax liability. You could be in for a nasty shock.
C Corp owners may want to rethink their business sale plans. Instead of selling all the stock in their company to get a low capital gains rate, they may want to retain some stock, deferring gains taxes and drawing dividends over time. (This strategy won't look as good if Congress doesn't extend the 15% dividend rate beyond 2008.)
LLCs are great sometimes, but ...
If you're starting a new business, the entity of choice of your attorney (for you) may be an LLC. It can be more flexible than an S Corp and has certain tax advantages. For example, you can create different shares of stock with different profit draws in an LLC, but not in an S Corp, if that is a potential issue. And when an LLC borrows money, it adds to your basis in the company; when an S Corp borrows, it doesn't. If, however, you are converting from a C Corp to a passthrough, an S Corp is preferable -- you can convert to an S Corp, but not an LLC, without triggering extra tax.
You'll need a C Corp to go public, if that is a future realistic concern. A C Corp might also work well if you are starting a sideline business and want to build up some capital. The first $50,000 of income in a C Corp is taxed at only 15%. Even if you do take those profits out, you'll still be better off paying a 15% corporate tax plus a 15% dividend rate which works out to a combined 27.75%. Anything above the $50,000 you can take as salary, so long as it's reasonable and not too obviously keyed to the level of profits. Warning: The lower rate isn't available for professional service corporations, like law firms.
And you must consider state corporate taxes, too. In Virginia, this isnt an issue for S Corporations - it all goes to the individual return, state and federal.
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