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C-Corp vs S-Corp

This question was posted on are recent entry on selecting the business entity type for consultants:

"From talking to a few accountants, they seemed to think that a C-corp was a better deal for many small businesses than the S-Corp because of additional medical reimbursement plans and other fringe benefits.

Can you comment on the benefits of S versus a C for a sole business owner (in California, say)?

Again, this assumes that you don't leave money in the C to be 'double-taxed' - it's either paid out in salaries, or used in pension plans, etc."

As with most things, it depends. If you are a consultant operating as a C-corp (which is just a regular coporation that hasn't made an S-corp election) it's likely your corporation is a PSC. Here's a snippet from the IRS web site.

"A corporation is a qualified personal service corporation if it meets both of the following tests:

1. Substantially all of the corporation’s activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and
2. At least 95 percent of the corporation’s stock is owned by employees performing services for the corporation, retired employees, the estates of employees, or other persons acquiring stock in the corporation by reason of the death of employees."

So for small retail or manufacturing companies, a C-corp will likely be a better option because the tax rates for corporations tend to be lower than personal rates. However, if your corp is a PSC, you are subject to the 35% flat tax.

You would need to look at your own specific situation to see if the medical benefits would outweight the additional federal tax imposed on PSCs. The rules regarding the deductibility of medical premiums have changed in recent years so S-Corps shareholders can deduct the medical premiums paid by their company. I would imagine that the taxes would be higher than any fringe benefits but again you need review your own situation to make a determination on which is better.

As far California goes, both C & S corporations are subject to an $800 minimum tax starting your second year and due every year thereafter regardless of profitiability. There's no special PSC rate for California income tax. The California tax rate for most C-corporations is 8.84%.

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I really wasn't that

I really wasn't that familiar with these specifics. I am actually planing to start my own business and begin gathering informations that I need. Your blog has determined to make the right decision and now I am actually want to apply for SBA loans.

Thanks for making it all

Thanks for making it all clear for me... As far as I know, although the income of a C corporation is taxed, the income of an S corporation (with a few exceptions) is not taxed under the Federal income tax laws. This is what makes it easier to choose between them. Of course there are also other aspects to consider here...

Gordman,
Start a corporation

Federal Taxes on an S-Corp.

Hi Gordman,

Actually, income from both the S & C corps pay federal income tax. The difference is the C Corp pays income tax directly & with a different rate structure. The taxable income of an S Corporation flows to the shareholder and is taxed at the shareholder's personal tax rates.

L:)

35% tax on PCS - on corp. income or personal ?

Hi
My apologies if this should be obvious. But...
You keep bringing the 35% up as a tax for PSCs, to which amount does this apply?
The question that led to this page also mentions "not leaving money in the C-corp" as in "the corporation does not make profit" - it's all payed out as salary.
What would be taxed at 35% in such a corporation?
Thank you
very consice and informative.

35% Tax on PCS

The 35% tax only applies to the corporate income.

In practice, it's often difficult to actually bring corporate net income down to zero year after year. If your business is a PSC, it's likely more tax savings can be had by making the S-Corp election and leaving excess earnings in the company for future growth and investment.

Remember, you have to pay income and payroll taxes on the amounts paid as salary. Let's say you're personally in the 25% bracket. By the end of the year when you're paying your final payroll to bring the profits to $0, you're paying over 40% tax on that check: 15.2% for both halves of the payroll tax, plus state payroll taxes and fed & state income tax. If you make the S election, all that money could be left in the corporation for future investment and you only end up paying your personal marginal rate, likely 25% in this example.

Another strategy to reduce taxes would be to use one of the retirement plans available. However, as a corporation, your contributions are limited somewhat by your salary. If you try to minimize your salary too much, then you also limit the amount of tax savings to be gleaned in retirement plans.

Also, in the past the IRS has challenged some business that have perennial losses arguing that these businesses are really hobbies, which opens a whole other can of worms. Even if you can make the argument your business is legitimate, most people are rather risk averse when it comes to dealing with the IRS. :)

As usual with taxes, there are a lot of subtle issues that need to be understood so you can make the tradeoffs that make the most sense for you.

L:)

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