Does a Regular C Corporation Really Allow You to Pay a 15% Tax Rate?

The political debates about Governor Romney's and Warren Buffet's relatively light tax bills sometimes trigger a question from successful small business owners. If Mr. Romney or Mr. Buffet pay only a 15% federal rate, can a small business also restructure itself so the owner pays the same low rate?

This is a great question. So I want to talk about why someone who's really financially successful may be to pay a 15% rate on much or even all of their income. And then I want to discuss whether one can use this information to pay lower taxes on a business's profits.

When Business Income Gets Taxed at 15%

Business-related income gets taxed at the 15% rate in two situations.

The first situation? If a regular C corporation uses its profits to pay dividends to a shareholder, the dividends get taxed at a 15% rate on the shareholder's tax return.

In other words, if someone receives $1,000,000 of these so-called "qualified dividends," the tax equals $150,000, or 15%.

And here's the second situation where someone gets to pay the low 15% tax rate. If a business owner or investor sells an investment held for longer than a year, any profit gets taxed at the 15%.

For example, if a business owner starts a corporation, grows the business, and then sells the corporation for a $1,000,000 profit, the business owner pays $150,000 in capital gains taxes on that profit.

Just to make this point crystal clear, then, suppose you've been a very successful private equity investor like Mr. Romney and each year you receive $10,000,000 in qualified dividends. In this case, under current tax law, you pay a federal income tax equal to $1,500,000 on your individual tax return.

Or, suppose you're a billionaire investor like Mr. Buffet and that each year you enjoy a $10,000,000 capital gain when you sell off chunks of long-term investments you own. In this case, under current tax, you pay a federal income tax equal to $1,500,000 on your individual tax return.

Note: I'm just using round example numbers here. I obviously don't know what Mr. Romney's or Mr. Buffet's typical tax returns look like.

Converting Your Business Income to 15%-tax-rate Income

Once you start thinking about the above tax rates and example calculations, you pretty quickly find yourself asking, "Hey, those 15% rates sound pretty good... how do I sign up for that?" And here's where things suddenly start to make a lot more sense...

Qualified Dividends

Let me start by talking about how you need to rearrange your business affairs in order to enjoy the 15% qualified dividends tax rate. A dividend becomes a qualified dividend when the money represents previously taxed profits. Corporate tax rates sort of average 34% once a business enjoys the sorts of profits we're talking about here.

Accordingly, if you did have a $1,000,000 of profit, the corporation would first have to pay a 34% corporate income tax rate on that income on the corporate tax return. That would leave you with $660,000 of money to pay a $660,000 qualified dividend.

On the $660,000 dividend, you would personally pay a 15% qualified dividends tax rate, or $99,000.

When the dust settled, then, you would receive $561,000 of cash in your pocket after paying both the 34% corporate tax rate and the 15% qualified dividend tax rate.

When you combine a 34% corporate tax rate and a 15% qualified dividends rate, your blended combined rate equals roughly 44% because you've paid roughly $440,000 of taxes on the $1,000,000 of pretax profit.

Without getting into the politics of whether Governor Romney or Warren Buffet should pay higher personal tax rates on qualified dividends, I assume we can all agree that if you're a business owner facing this decision point you do not automatically choose to have your corporation taxed as a C corporation in order to pay the 15% qualified dividend tax rate. You need to consider the extra 34% corporate tax you also have to pay.

Long-term Capital Gains

The capital gains rate thing is a little trickier to do the accounting for. But you can get good insight into this tax planning opportunity if I keep the example simple.

Let's say that you have a business that makes, pre-tax, $1,000,000 a year. Suppose, for sake of illustration, that you pay the $340,000 of corporate taxes on that profit and then leave the remaining $660,000 invested in the business. In other words, assume you use this money to grow your business.

Finally, assume that after ten years of this reinvestment-driven growth, you sell the business for a $10,000,000 profit.

In this case, your $10,000,000 of profit will be taxed at a 15% capital gains rate under current tax law. So you will net $8,500,000. But do note that over the decade of reinvestment-driven growth, you indirectly through your corporation pay $3,400,000 of corporate income taxes.

In this case, your net $8,500,000 of capital gains equals roughly 63% percent of the $13,400,000 in profit you enjoyed. (I calculate the $13,400,000 by adding together the $8,500,000 in net-of-tax proceeds, the $1,500,000 in capital gains taxes and the $3,400,000 in corporate income taxes)... And these numbers means you've paid nearly al 37% federal tax rate.

The upshot? On your personal tax return, the federal tax rate may show up as 15%. However, when you think about the fact that much of the capital gain comes from reinvested, previously tax profits, the real tax rate you pay as the owner pays runs a lot higher.

Note: In the example of a $10,000,000 gain on sale stemming from a reinvestment of $6,600,000 of corporate profits, the $6,600,000 of corporate profits gets taxed with twice and the other $3,400,000 gets taxed once. This blending of double-taxed profits and single-taxed profit explains the slightly lower tax rate produced by the second set of example calculations.

The Reality Sandwich for Business Owners

The politicians and media pundits who debate such things can argue about whether the tax rate in the preceding example cases equal 15%.

If you do the sort of accounting that any business person would do, however, you absolutely won't see the tax rate as equal to 15%. Yes, the taxes paid on the individual tax return equal 15%. But that simplistic calculation ignores the 34% corporate tax rate the business has paid first inside the corporation on either all or a large portion of the money now, later, being taxed at 15%.

Accordingly, you typically would not for tax-rate reasons choose to operate your business as a C corporation. Typically, an S corporation minimizes the federal income taxes you pay.

Looking Ahead to 2013 and Beyond

I want to make handful of additional comments, too. These comments don't change the overall conclusion I propose in the paragraphs above. In fact, they only make the conclusion stronger and more robust.

First comment: When the Bush tax cuts expire (or probably expire) in 2013, the qualified dividends tax rate will go away. Without that "qualified dividends" preference, the combined tax rate will get even higher. With a 34% corporate tax rate and a 40% ordinary income tax rate, for example, the combined federal tax rate is over 60%.

Second comment: When the Bush tax cuts expire (or probably expire) in 2013, the long-term capital gains rate rises from 15% to 20%. With a higher long-term capital gains rate, again, the combined tax rate on capital gains profits will also get higher. For example, if I redo the calculations for the capital gains example given earlier, the combined rate rises from roughly 37% to roughly 40%.

A third comment: Starting in 2013, the Affordable Care Act (aka Obamacare) levies a new 3.8% Medicare surtax on the qualified dividends and capital gains when these amounts get into the ranges described in the preceding paragraphs. For example, the combined, effective qualified dividends tax rate might equal roughly 63.8% and the combined effective long-term capital gains tax rate might equal roughly 43.8% once one includes the effect of Obamacare.

Fourth, remember that most states also levy both corporate and individual income taxes. Accordingly, the numbers given above in most states represent the majority of the business owner's tax burden--but certainly not all of the business owner's tax burden.

Additional Information You May Find Useful

If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of my downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.

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