“I selected an S Corporation to safeguard my personal assets through limited liability protection while enjoying pass-through taxation, allowing business profits to flow directly to my individual tax return and avoiding the double taxation faced by C Corps.”—Marwan Mezher
Many taxpayers build lasting companies with solid reputations and solid liability protection. Corporations, profit or nonprofit, are single or allied individuals authorized by the state to act as independent business associations with legal personality. Stocks issued can be sold with capital gains. C corporations pay 21% corporate income taxes, while shareholders pay individual income taxes on salaries and dividends. With a form 2553 election, S-Corporations avoid double taxation by passing through tax attributes to shareholders on Forms K-1.
Corporate Startups
Corporations start with dreams, and Marwan Mezher, MBA, chose an S-Corporation to share higher level math, reading and computer engineering. Register new corporations with California’s Secretary of State and pay $800 yearly for legal protection from liability. On Forms 1120, the IRS taxes dividends, wages or gains for C corporations or diverse K-1 income on Schedule E. The IRS limits S-Corps to 100 shareholders, all citizens or legal residents.
S-corps owners prefer dividends, which avoid double taxation and payroll taxes but must pay salaries that the IRS Form 1120S instructions limit to “reasonable compensation for services rendered to the corporation.” “Reasonable compensation” arguably depends on “facts and circumstances” like the training and experience of the employee, the duties involved, comparable salaries, dividend history or compensation agreements.
“The main downside has been the added administrative requirements,” writes Mezher, “like setting a reasonable salary for payroll compliance.”
But larger corporations must hold board meetings, maintain minutes and even file elaborate accounting records with the SEC that make stock analysis predictable. They can write off employee benefits, including payroll taxes, medical premiums and fringe benefits like life insurance, long-term care and disability or life insurance, and may show little income. Charity reduces taxable income while NOL carries losses over multiple years.
Loopholes for Small Corporation Owners?
Internal Revenue Codes let taxpayers play games that create jobs with American investments:
• IRC Section 83(b) lets optimistic startup entrepreneurs receive stock for services valued on the day of receipt but paid years later with substantial risk of forfeiture, while Section 351 allows tax-deferred transfers of property to corporations when transferors hold 80% stock control.
• IRC Sec. 4975 allows exemptions from prohibited transactions, which legalize 401k or IRA business financing in “Rollovers for Business Startups” arrangements. This risky strategy frequently involves favorable determination letters from the IRS, fiduciary bonds, payroll companies and IRS Form 5500 for 401k’s with full disclosure to employees.
• IRC Section 1202 lets C Corps with assets under $50 million issue new Qualified Small Business stock at the original cost of assets. If owners hold the original issue stock for five years or make qualified trades, they can exclude 50-100% of gains on sale with limits of the greater of $10 million or 10 times the basis of QSB stock sold yearly.
• IRC Sec. 302 affords a shareholder the advantage of favorable sale or exchange treatment–capital gains after basis is redeemed tax free—on redeemed stock but only if the redemption is not a dividend and meets other tests.
Good Corporations Rise or Fall
S-corp dissolutions involve complicated tax rules. Sellers can pay capital gains rates if held over one year, and the buyer gains the corporations’ balances. Or buyers seeking stepped-up basis can purchase corporate assets with the corporation paying taxes on gains and shareholders paying varied taxes on liquidating distributions.
Sales prices can also be allocated amongst assets and CA may impose franchise taxes. Buyers prefer asset sales to get stepped up basis but sellers prefer stock sales for lower capital gains rates. Of course, shareholders sell C Corp stocks on exchanges or in private transactions with gains or losses. Dissolve corporations to avoid costly penalties and needless tax filing.
With entrepreneurial success, Mezher now “mentors founders and professionals on how to leverage AI, data-driven marketing, effective sales systems and strategic business planning.” Professionals may use S-corps to shield assets from lawsuits and taxes, but the savviest of investors make fortunes when corporations go public or stocks split. C corporations alone raise capital sufficient for modern industry.
Robert Arne, EA, CFP, MS, of Carpe Diem Financial Life Planning, is a Santa Cruz Mountain Certified Financial Planner who gives holistic financial advice as his client’s fee-only fiduciary. These articles are not personal financial, mortgage, tax or investment advice; consult appropriate professionals. Learn more at www.carpediem.financial.
