Top 3 Myths About C Corporations for Small Business Owners

Myths About C Corporations for Small Business Owners

When it comes to tax planning, I believe that forming a C corporation can be one of the biggest pitfalls for small business owners. It’s surprising how many lawyers still promote this structure to entrepreneurs, despite it often being unnecessary and potentially costly for most small businesses.

Large corporations have different priorities compared to small businesses, and tax savings are typically not at the top of their list. Small business owners, on the other hand, have very distinct needs. Most of the time, these needs can be met without the complexity and double taxation issues associated with C corporations. Instead, an LLC or S corporation often provides a simpler and more effective solution.

Debunking Common Myths About C Corporations

Unfortunately, there are persistent myths that push small business owners toward choosing a C corporation, even when it’s not the best fit. Here are three of the most common misconceptions that are used to sell C corporation packages to entrepreneurs who don’t actually need them:

1. The Myth of Extra Tax Deductions: Many believe that a C corporation offers additional tax deductions, but in reality, the benefits are often overestimated and can be outweighed by the drawbacks.

2. The Myth of Lower Corporate Tax Rates vs. Personal Tax Rates: It’s a common belief that corporate tax rates are always lower than personal tax rates, but this isn’t always the case. Depending on your situation, you may find that an S corporation or LLC offers better tax efficiency.

3. The Myth of Avoiding Double Taxation with a Higher Salary: Another common misconception is that you can avoid the double taxation issue associated with C corporations simply by paying yourself a higher salary. However, this approach often falls short and can lead to other complications, making it less effective than many believe.

Myth 1: Extra C Corporation Tax Deductions

Proponents of the C corporation often argue that the entity offers a wealth of extra tax deductions that can significantly reduce your net income. This argument is frequently supported by tax book authors, self-proclaimed experts at seminars, and scripted call center representatives who promote these “exclusive” deductions as a major selling point of the C Corp structure.

While it’s true that S corporation owners are restricted from taking certain deductions—particularly if they own more than 2% of the business—this doesn’t mean the C Corp is automatically the better option. The belief that you can only access valuable tax write-offs through a C Corp is often overstated, and the perceived benefits may not outweigh the additional complexity and potential tax burden.

If you are more than a 2% stakeholder in an S corporation, you cannot anyways take the following deductions:

(a) Disability insurance

(b) Health reimbursement arrangements

(c) Day-care assistance plans

(d) Educational assistance programs

(e) Cafeteria plans

While these deductions might seem appealing at first glance, it’s important to evaluate their real impact. Here are a few things to consider:

1. Limited Usability: Not everyone can take advantage of these deductions, as they often require specific circumstances that might not apply to your situation.

2. Minimal Long-Term Benefit: These write-offs may not add up to significant savings over time, meaning their impact on your overall tax strategy could be minimal.

3. Employee Requirements: If you have other employees, you’ll need to extend these benefits to them as well to qualify for the deductions, which could increase your costs.

Before deciding whether these deductions are worth the complexities of a C corporation, ask yourself some key questions. Can you afford to purchase disability insurance? Do you have children in daycare or are you returning to school, making educational write-offs essential? Are you aware that you can manage healthcare expenses creatively using a Health Savings Account (HSA) or a Section 105 Health Reimbursement Arrangement?

Myth 2: The Lower C Corporation Tax Rate

Another myth that often entices small business owners is the promise of a lower tax rate through a C corporation. The idea is that, because C Corp is subject to a flat 21% tax rate on all its net profits (down from the previous 15% on the first $50,000), this rate might seem lower than personal income tax rates, potentially offering tax savings.

However, this is a risky game that can quickly backfire if not handled with extreme caution. To realize these perceived savings, some advisors might suggest that you pay the corporate tax and keep the profits within the C corp. By doing this, you supposedly avoid double taxation—first at the corporate level, and then again when you withdraw the money as personal income.

But here’s the catch: the money remains trapped within the corporation. If you eventually want to access those funds personally, you’ll still face personal income tax, nullifying any supposed advantage. In the end, this strategy often leaves your money stuck in the corporation, limiting your financial flexibility and defeating the purpose of tax savings.

Leaving profits within a C corporation might seem like a smart move initially, especially if you’re looking to avoid immediate personal income tax. However, this strategy merely postpones the inevitable. Eventually, you’ll want to access those funds, whether by pulling them out of the corporation or paying off any loans. When that time comes, you’ll face individual income tax on the retained earnings or distributions, erasing any earlier tax benefits. Keeping the money in the corporation only delays this tax burden, rather than eliminating it.

Moreover, when you factor in the new 20% 199A pass-through deduction available to S corporations, the tax advantages of an S Corp become even more compelling. This deduction significantly boosts the tax savings compared to a C Corp, especially when considering the differences between corporate and personal tax rates.

Myth 3: The Higher Payroll Solution

At the end of the day, your goal with any business is to generate profit, right? But after taking advantage of all those enticing C corporation deductions, how do you plan to withdraw your profits without incurring double taxation? One common suggestion is to simply pay yourself a higher salary. But this approach has its own set of problems.

If you opt to take a loan from the corporation, you’re merely delaying the inevitable tax hit. When you eventually close the C Corp, those taxes will come crashing down like a ton of bricks. It’s a ticking time bomb that could explode your financial plans.

So, where will you hide the profits, you intend to make? When confronted with the issue of corporate income, C Corp advocates often suggest increasing payroll to offset the income. But this so-called solution doesn’t address the underlying problem—it only shifts the tax burden to a later date, complicating your tax situation even further.

Let’s take a moment to consider the implications of using a larger salary to eliminate the net income of the corporation. If you increase your salary to wipe out the corporation’s net income, what are you actually paying more of? Payroll tax! That’s the very same 15.3% self-employment tax (SE tax) we were trying to minimize by opting for the S corporation strategy in the first place. If C Corp requires you to take a higher payroll, what’s the benefit? In contrast, with an S Corp, you can take a lower salary and avoid corporate tax on the net income altogether, making the S Corp the clear winner in this scenario.

Then, there’s the more aggressive—and usually ineffective—strategy of setting up multiple corporations or paying fees to other companies to attempt to move or hide your corporate income. The IRS has made it abundantly clear that sheltering income across multiple corporations to avoid taxes is not an acceptable practice. If anyone presents this strategy to you, consider it a red flag and walk away. However, if you find the argument convincing and are on the verge of committing, it’s crucial to seek a second opinion from a licensed CPA.