Businesses have to make choices that typically involve trade-offs. Sometimes the impact is minor and does not take a great deal of analysis (e.g., should the walls in the breakroom be painted off-white or beige?).
Other decisions can have significant long-term impact on the company and its owners. And the trade-offs can be painful.
One such decision many business owners face is whether to organize as a C or S corporation. While both structures offer limited liability to the owners, there are advantages and disadvantages to both approaches.
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As the following table illustrates, the tax treatment is dramatically different and has a very real impact on how a business manages its capital:
| C Corporation | S Corporation |
Tax Treatment | A C Corporation is a taxable entity.
The business pays tax on its income.
Federal taxes are typically in the 35-percent range.
If the company pays a dividend, shareholders are taxed on that dividend. As a result, C Corporations are often said to face double taxation.
| An S Corporation does not pay taxes directly.
It is a flow-through entity, meaning the income is passed through proportionately to shareholders who pay taxes.
The net result is typically a smaller total tax burden. Distributions to shareholders are tax exempt to the extent they are from previously taxed income.
|
Capital Management | Companies set dividend policies to attract certain types of investors, for example, those who want current income look for companies that pay high dividends and manage their capital.
Companies that want to retain capital to finance growth, acquisition, etc., can choose to pay little to no dividends and retain the funds for other purposes.
| S Corporations tend to pay out all, or the majority of, their earnings because the owners are taxed on earnings even if they are retained.
As a result, S Corporations tend to be restricted in their ability to grow. |
Let's look at an example:
Assume a company is valued at $20 million, producing pretax profits of $2 million per year.
If the company were organized as a C corporation, assuming a federal business income tax rate of 35 percent, the business would owe $700,000 in taxes. Any dividends paid to the owner would be taxed at the dividend rate. Retained earnings would be taxed a second time when distributed. If the owner received dividends of $500,000, assuming a dividend tax rate of almost 24% (assuming a qualifying dividend rate of 20% and an additional 3.8% Medicare investment tax), there would be an additional $120,000 in taxes due.
If the company were organized as an S corporation, the full $2 million in profits would pass through to the owner and be taxed at his or her individual federal tax rate. The taxes due would likely approximate $700,000. The owner would likely need a distribution of at least the amount due in taxes (both federal and state) to pay the income tax. However, given that the owner has been taxed on the full earnings, he or she is more likely to take a distribution of the total earnings—leaving no capital for business growth.
So companies wanting to take advantage of the tax treatment of an S corporation face the trade-off of lower capital reinvestment in order to have lower taxes.
But it is possible to have both.
Thousands of S corporation companies have found a way to do just that through Employee Stock Ownership Plans (ESOPs).
ESOPs are qualified defined contribution retirement plans that are invested primarily in the common stock of the sponsoring company. Establishing an ESOP can be an effective way to help a business owner sell some or all of the company as part of a plan for ownership succession.
An ESOP can also be an effective approach to reducing business taxes and managing capital structure.
Let's look at the tax impact when our $20 million dollar company is structured as an S corporation and the owner has sold 100 percent of the stock to an ESOP trust.
Because the company is an S corporation, it would pass its earnings ($2 million in taxable income) through to the shareholder, the ESOP trust. As a result of the tax treatment of S corporations, the ESOP trust would not immediately owe any federal income taxes. Rather, taxes are due when a participant has a benefit event and takes a distribution, as with other qualified retirement plans.
So instead of paying $700,000 in taxes or distributing amounts to shareholders, the money remains in the business to fund operations, expansion, etc. This reinvestment in the business often leads to higher share prices (and retirement plan balances) and therefore greater total taxes at benefit distribution.
The ESOP allocates shares to employees as a retirement benefit over time. As with other qualified retirement plans, the taxes are not eliminated but are deferred until employees have a benefit event. At that time, the individuals' ordinary income tax rate applies.
For many companies, forming an S corporation and selling part or all of the business to an ESOP provides significant benefits — to the owners who have a succession plan, to the business that has more capital to grow and to the employees who have the potential to accumulate a significant nest egg for retirement.
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