Entrepreneurs love solving puzzles, and one of the more complicated puzzles to try and piece together is deciding whether C corporation status makes sense for your business.
Incorporating a business can be expensive and involve ongoing paperwork and compliance requirements. Some businesses should steer clear of the headaches required of maintaining C corporation status.
Other businesses, however, will gladly invest the extra time and money required to incorporate. For businesses that use the C corporation entity structure correctly, the decision to incorporate an offer is a very attractive legal and tax planning option.
C corporation: The preferred tax shelter from the 1940s to the 1980s
The top marginal tax rate for individual U.S. taxpayers in the 1970s was 70%. Lest you think this 70% rate for the well-off U.S. citizens is too low, you’re in luck. The top marginal rate hovered in the low 90s between 1952 and 1963.
The all-time high tax rate for individuals occurred during World War II, peaking at 94% in 1944 and 1945 for taxable income exceeding $200,000 ($2.5 million in today’s dollars).
So why are we giving you a history lesson about individual tax rates in an article about C corporations?
The U.S. citizens who would have been subjected to these top marginal tax rates surely would have found a way to avoid paying 70%, 80%, or 90% of their income to Uncle Sam. And that preferred way of sheltering their income in the post-World War II era of the American economy was the good-old C corporation.
From tax shelter to forgotten business entity
During the 1950s, when the top individual rate was in the low 90s, the top tax rate on traditional C corporations was 52 percent, almost 40 points lower than the top individual income tax rate.
Even when President John F. Kennedy lowered the top individual rate to 70 percent in 1963, there was still a spread of 22 points when compared with the top corporate rate of 48 percent.
Wealthy taxpayers simply shifted as much of their entrepreneurial income as they could from their individual tax returns into a C corporation.
Continued use of C corporations as a tax shelter by the wealthy started to slow in 1981 thanks to President Ronald Reagan. The top individual rate was lowered from 70 percent to 50 percent while the corporate tax rate held steady at 46 percent.
An expansion in the total number of allowable shareholders in an S corporation and the creation of a new entity called the Limited Liability Corporation also decreased the use of C corporations during the early 1980s.
In 1986, the top individual tax rate of 28% finally dipped below the top corporate tax rate of 34%. Wealthy taxpayers who were still sheltering income using C corporations immediately began reporting most of their income on their individual tax returns by flowing business profits through sole proprietorships, S corporations, or LLCs. Between 1986 and 1996, S corporations and LLCs overtook C corporations as the business entity of choice.
As a comparison, in 1958, C corporations and Partnerships (LLCs) numbered roughly 1 million each, with hardly any S corporations in existence. By 2010, C corporations stood at 1.5 million while Partnerships (LLCs) grew to 3.4 million, and S corporations grew to 4.2 million.
With the proliferation of Partnerships and S corporations, C corporations were now the forgotten business entity, and then tax reform happened.
The effect of the tax reform bill
Just when it looked like S corporations and Partnerships would be the preferred business entity of choice into the indefinite future, President Donald Trump and the U.S. Congress passed the “Tax Cuts and Jobs Act of 2017” in December 2017. This statute lowered the top corporate tax rate from 35% to 21%, which is 16 points lower than the 2019 top individual rate of 37%.
Is it possible that wealthy Americans will shift their business income from S corporations and LLCs back to C corporations? While the tax reform bill lowered the Federal tax rate to 21 percent, it also made available certain advantages to the specified individual and trust owners of partnership and S corporations with a special 20 percent income deduction.
So stay tuned to find out how many S corporations and Partnerships find it more advantageous to switch back to being a C corporation.
Formed by filing Articles of Incorporation at the state level.
Both C corporations (and S corporations) are born the same way, by filing Articles of Incorporation with the state in which you want to conduct business. When Articles of Incorporation (also called Certificate of Incorporation or a corporate charter) are filed with the state, your business officially becomes a legal entity separate from its owners called a “corporation.”
Corporations by default must follow the taxation rules contained in Subchapter C of the Internal Revenue Code, hence the name C corporation. (S corporations are taxed according to Subchapter S of the tax code.)
Think of Articles of Incorporation as an application a business fills out to become a “corporation.” While rare, Articles of Incorporation can be rejected for various reasons.
Once approved by your state, Articles of Incorporation become a matter of public record.
Most states require at least the following information to be included with the Articles of Incorporation: Corporate name; Business purpose; Registered agent; Incorporator; Number of authorized shares of stock; Share par value; Preferred shares; Directors; Officers; and legal address of the company.
Did you know you can incorporate your business in any state you want to?
Many businesses choose to incorporate in the state where they conduct most of their business or where their headquarters is located. Corporations, however, have the flexibility to file their Articles of Incorporation in any state.
Incorporating in the same state where your business is located is often the cheaper alternative. If you incorporate in a different state, you’ll still need to pay a fee to register your company in the state where your business is located, in addition to paying a fee to the state where the Articles of Incorporation are filed.
The Delaware C corporation is the gold standard
If you want to file your Articles of Incorporation in a state other than where your business is physically located, Delaware is always a popular choice for several reasons.
First, the Delaware General Corporation Law offers very flexible terms with how a business can structure its corporation and board members. For example, Delaware permits only one individual to be the sole shareholder or officer of a corporation, while other states mandate a minimum of three people holding positions of officer or director.
Second, the Delaware Court of Chancery is the most well-known and respected business court in the United States. This court hears a high volume of corporate cases, which means more predictable outcomes where legal advisors can be on the lookout for precedents and rulings on past cases. The court also uses judges instead of juries. If you find yourself involved in corporate litigation in Delaware, your case will be assigned to a judge who is an expert in complex corporate law matters.
Third, the incorporation process is faster in Delaware than most other states. Delaware also doesn’t require the business to publicly disclose the names of the corporation’s directors or shareholders, which offers an additional layer of privacy.
Finally, Delaware C corporations are preferred by venture capitalists and investment banks. Venture capital firms and angel investors sometimes require start-ups to be Delaware corporations before funding is provided. According to Delaware’s “Division of Corporations” website, more than 66% of Fortune 500 companies have chosen Delaware as its legal home.
Strict year-end requirements for properly maintaining C corporation status
A common reason for incorporating a business is to limit the personal liability of the shareholders if the company is sued. Limiting personal liability, however, isn’t a benefit that’s granted indefinitely after the Articles of Incorporation are filed.
A C corporation must remain in good standing with the state in which the Articles of Incorporation were filed (this also applies to LLCs) at all times by adhering to a prescribed list of rules in order to maintain limited liability. If the corporation finds itself not in good standing, a third party can sue the business and come after both the business’s assets as well as the shareholders’ assets. This is commonly referred to as “piercing the corporate veil.”
Here are some of the most common rules that must be followed to maintain a C corporation’s “good standing”:
- File annual information reports – Most states require some type of annual information report. Double-check due dates – some reports need to be filed when tax returns are due, others are due on the anniversary of the incorporation or at the end of the calendar year.
- Keep corporate minutes and resolutions – Minutes, also known as “minutes of the meeting,” are the contemporaneous written record of a meeting. Minutes content typically includes time and place of meeting, individuals in attendance and the chair of the meeting, decisions made or actions are taken, along with the signature of the recorder and the date. Meeting minutes should be recorded even if there is only one corporate owner. Minutes are often used as a defense in court to protect a corporation’s ability to limit shareholder personal liability.
- File amendments to record any changes – Changing an address, changing a website URL, issuing more shares of stock – any change to the corporation must be reported to the corporation’s home state by filing an “amendment” to the original articles of incorporation. Many states refer to these changes as “Articles of Amendments.”
- Keep business finances separate from personal finances – For a small business owner, keeping separate checking accounts for business and personal transactions can be a hassle. But if you incorporate your business, maintaining separate accounts is a requirement. There should be separate accounts for everything money-related in a corporation – checking accounts, savings accounts, credit cards, etc. Keeping separate business accounts will also make tax time easier since all business income and expenses will be in one place.
- Register in all states where the corporation conducts business – A corporation operating in a state other than where the Articles of Incorporation were filed is referred to as a “foreign corporation.” Other state-specific licenses and permits may also be required.
Corporate bylaws set rules and are enforced by the board of directors
Bylaws are the rules of a corporation that will be performed throughout the organization’s existence. Bylaws govern how a company is operated and are one of the first items to be created by the board of directors. While the bylaws are often included with the Articles of Incorporation as a single document, bylaws, and Articles of Incorporation are legally separate, distinct documents. Bylaws are not required to be filed with the state of origin’s agency of business registration.
Bylaws should contain the following sections:
- Board of Directors – The board is the governing body of the corporation. The bylaws should outline the board’s powers and duties, the number of years a member can remain on the board, the number of members required to form a quorum, and how to replace a member.
- Identification Information – Name, address, and principal place of business; designation of the corporation as public or private
- Stock Information – If the organization is a stock corporation, the bylaws should have information about stockholders and voting shares of stock, the number, and type of shares, and the types of stock classes the corporation is authorized to issue
- Statement of the Company’s Purpose – Explains why the company was formed; may be helpful with attracting investors because of a central location to ascertain what the company is all about
- Shareholder and Board Meeting – Bylaws should indicate when, where, and how often shareholder meetings take place and how to notify shareholders of these meetings.
Preferred entity structure for institutional investors (i.e. venture capitalists)
C corporations make dividing ownership easy through the issuance of stock. Dividing ownership can also be done with other entity forms, such as LLCs, but it is significantly more complicated.
Ease of dividing ownership is one reason why institutional investors prefer – and sometimes require – a business to be a C corporation.
Some investors don’t want just any C corporation – they prefer a Delaware C corporation. As detailed in an earlier section of this article, the state of Delaware features a corporation-friendly court system as well as formation flexibility.
If you know for certain that your business will be welcoming investors in the future, consider making your business a C corporation from the very beginning. You can always start a business as an LLC or an S corporation, then convert to a C corporation, but that process could be very expensive and time-consuming.
Easier to issue stock-based compensation packages
In the early days of a start-up company when cash can be at a premium, new employees can be incentivized to work for the start-up by being offered equity incentives. Stock-based compensation packages are also a great way to tie the employee’s financial rewards to the success of the company.
Several of the equity-based incentive plans allow employees to defer paying tax on the equity compensation they receive until the underlying stock associated with the incentive package is sold. When the employee sells the stock at some point in the future, the employee will then recognize income and the business can recognize a wage and salary deduction.
While LLCs can offer their members or partners what is called a “future profits interest,” it can’t offer a future value of the partnership as a compensation arrangement. So if the business wants to tie compensation to the equity of the business, the C corporation is the easiest way to structure this type of pay package.
Stock Options and Restricted Stock
Most equity compensation packages are offered as either grants of stock options or issuances of restricted stock. Stock option plans are more common with startups while restricted share plans are more common for established companies.
Here is a quick look at the most common types of stock grants and options:
- Stock Grant of Restricted Shares – Restricted shares are shares of a business’s stock that vest over time to an employee. An employee cannot sell the stock until the shares have vested. Receiving restricted shares is not a taxable event and doesn’t cost anything to the employee. When a restricted share finally vests, the employee must recognize the vested share’s fair-market value as ordinary income. The employee also must pay either short-term or long-term capital gains when the stock is eventually sold.
- Stock Grant of Unrestricted Shares – Rather than restricting when an employee can be awarded stock of a business, shares can be immediately transferred outright to the employee. While receiving unrestricted shares gives an employee immediate equity in a company, it also means the employee must immediately pay taxes on the fair market value of the shares less the amount paid for the shares.
- Incentive Stock Options – With an Incentive Stock Option (ISO) compensation plan, the employee does not have to pay taxes until the stock is sold. If certain holding period requirements are met, the stock sale proceeds will also be eligible for long-term capital gains treatment. With ISO’s, the C corporation does not receive a deduction when the employee sells his or her shares if the long-term capital gain holding requirements are met.
- Non-Qualified Stock Options – With a Non-Qualified Stock Option (NQSO) compensation plan, an employee is permitted to acquire an agreed-upon number of stock shares at a future date (or dates) for a pre-determined price. (These plans are called “non-qualified” because they do not meet all the criteria required by the IRS to qualify as ISOs.) For example, an employee is hired January 1, 2022 and provided an NQSO plan. The NQSO states that the employee can purchase one share of the company’s stock for $50 at a future date. On January 1, 2024, the employee purchases one share of company stock for the agreed-upon $50 while the fair market value of the share was $60. The employee must include as income on their tax return the fair market value of the stock at the time it was acquired less any amount paid for the stock. In our example, the employee would have to include income of $10 (FMV of $60 less $50) as income on their tax return.
Profits of a C corporation go into a bucket called “accumulated earnings and profits.” A dividend is a distribution made to shareholders from cash found in this “accumulated earnings profits” bucket. So another way to think about dividends is that they are distributions of earnings by a corporation to its stockholders.
But how, exactly, do dividends end up in the hands of stockholders? Only the board of directors can declare dividends. Dividends are usually paid quarterly, though a company can issue special, one-time dividends under special circumstances.
Easier for mergers, acquisitions, and IPO readiness
Instead of starting a business from scratch, suppose you wanted to buy a business instead.
One option is to purchase the individual assets of the company you wish to acquire. There would be separate transactions for all the assets on a balance sheet – accounts receivable, fixed assets, inventory, any intangible assets, etc. If there were any liabilities, those also might affect the purchase price of the assets.
Entering into separate transactions for each of a business’s assets can quickly become very cumbersome.
Instead of buying individual assets, a C corporation allows a potential buyer to purchase the company via shares of stock. Each share represents a fractional amount of the balance sheet, which makes mergers and acquisitions which are completed via stock swaps quick and easy.
B-Corporations (benefit corporations) are also C corporations with a specific designation
A Certified B-Corporation, also known as a benefit corporation, is a type of for-profit corporate entity recognized by 35 states and the District of Colombia. These corporations create value not only for their stockholders but also for society at large.
B Corporations are companies certified by “B Lab” as meeting certain standards of social and environmental performance, accountability, and transparency.
Don’t be fooled by the name “benefit corporation,” however. B-Corporations are taxed just like C corporations. They are not considered non-profit entities.
C corporation tax rates
As previously mentioned, C corporation profits are actually taxed at the entity level, unlike SMLLCs and S corporations, whose profits are taxed at the individual shareholder or owner level. The current tax rate for C corporations is a flat 21%.
When are C corporation tax returns due?
Tax returns for calendar-year C corporations are due April 15. C corporations must also make estimated tax payments if required. First-quarter payments are due April 15th; second-quarter payments are due June 15th; third-quarter payments are due September 15th; fourth-quarter payments are due December 15th.
A C corporation with a fiscal tax year must generally file its tax return by the 15th day of the 4th month after the end of its tax year. The one exception to this rule is for a C corporation that has a fiscal year ending June 30th, whose due date is the 15th day of the 3rd month after the end of its tax year (i.e. September 15th).
How are C corporations taxed?
A C corporation files its tax return on Form 1120. (Don’t confuse this form with Form 1120-S, which S corporations use to file tax returns.) Shareholders can receive money from the corporation in the form of wages or salary (for which they would receive a Form W-2), or dividends (reported on Form 1099-DIV), but a C corporation shareholder does not report an allocated amount of revenue and expenses as an S corporation shareholder does.
This section discusses filing a C corporation tax return. Please contact our office with any questions about filing a Form 1120, Form 1099-DIV, or a Form W-2.
- Keep your accounting records and financial statements up-to-date. An accurate balance sheet and income statement helps to make preparing your C corporation tax return extremely easy every year and will ensure that you don’t run the risk of reporting too much (or too little) income. If your business grows big enough, you’ll be required to report your balance sheet on Schedule L of your C corporation’s tax return.
- Record your income. The first section of Form 1120 is where your business’s income and cost of goods sold are recorded.
- Record your expenses. The second section of Form 1120 is where your business’s expenses are recorded.
- Calculate your net profit or loss. Subtract your total expenses from your gross income to compute your net profit or loss. On a C corporation tax return, the technical name for your business’s profit or loss is “taxable income (or loss)”.
- Calculate taxes owed and payments made. Calculate your C corporation’s tax liability according to the Form 1120 instructions. Also, record any payments made during the tax year along with any tax credits.
- Determine balance owed or overpayment. The final dollar amount on Page 1 of your Form 1120 will tell you either how much money you still owe the U.S. Treasury or how much money you overpaid to the U.S. Treasury.
- Complete Schedule C. This schedule calculates any dividends that will be distributed to shareholders, along with various special deductions.
- Complete Schedule J. This schedule is where you will compute the tax liability of your C corporation.
- Complete Schedule K. This schedule contains miscellaneous questions and information about your C corporation.
- Complete Schedule L. If required, complete Schedule L. This is where you would report your business’s balance sheet.
- Complete Schedule M-1. This schedule is where you reconcile taxable vs. non-taxable income and deductible vs. non-deductible expenses.
- Complete Schedule M-2. This schedule is a more detailed look at the C corporation’s retained earnings.
Find out more about how other business entities are taxed:
This blog article is not intended to be the rendering of legal, accounting, tax advice, or other professional services. Articles are based on current or proposed tax rules at the time they are written, and older posts are not updated for tax rule changes. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.