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

The political debates during the 2012 presidential election about Governor Romney's and Warren Buffet's relatively light tax bills sometimes triggered a question from successful small business owners. If Mr. Romney or Mr. Buffet were able to 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 we'll talk about why someone who's really financially successful may be to pay a 15% or (starting in 2013) a 20% income tax rate on much or even all of their income. And then we'll 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 may be 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 very possibly get taxed at a 15% rate on the shareholder's tax return.

In other words, if someone receives $100,000 of these so-called "qualified dividends," the tax very possibly equals $15,000, 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 very possibly gets taxed at the 15%.

For example, if a business owner starts a corporation, grows the business, and then sells the corporation for a $100,000 profit, the business owner very possibly pays only $15,000 in capital gains taxes on that profit.

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. And corporate tax rates sort of average 34% once a business enjoys the sorts of success we're talking about here. Accordingly, if your share of a successful corporation meant you did have (prior to paying any income taxes, business or personal) a $100,000 of profit, the corporation would have to pay a 34% corporate income tax rate on that income on the corporate tax return.

That would leave you with $66,000 of leftover money to pay a $66,000 qualified dividend. And, yes, absolutely, on the $66,000 dividend, you would personally pay a 15% qualified dividends tax rate, or $9900.

But look at what's happened. When the dust settles here, you have received $56,100 of cash after paying both the 34% corporate tax rate and the 15% qualified dividend tax rate.

When you combine all the taxes you're paying, you've paid roughly $44,000 of taxes, a 44% rate, on the $100,000 of pretax profit.

Without getting into the politics of whether successful business owners 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 those extra corporate income taxes you 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, $100,000 a year. Suppose, for sake of illustration, that you pay the $34,000 of corporate taxes on that profit each year and then leave the remaining $66,000 invested in the business. 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 $1,000,000 profit.

In this case, your $1,000,000 of profit will be taxed at capital gains rates that run between 15% and 20%. So you will net between $800,000 and $850,000. But do note that over the decade of reinvestment-driven growth, you indirectly through your corporation pay $340,000 of corporate income taxes.

Now if you examine just your individual tax return, the tax rate looks pretty low. Maybe 15% to 20%. But the tax that shows on your personal tax return is only part of the tax bill. As per our example, you've also paid another $340,000 of corporate income taxes on much of this money.

In total, then, the federal government's share includes $340,000 of corporate income taxes and $150,000 to $200,000 of capital gains taxes. Your share equals $800,000 to $850,000. And that's great. Be thankful. But the taxes you've paid per my calculations run 37% to 40%.

The upshot? On your personal tax return, yes, the federal tax rate may show up as 15% or 20%. 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 is about twice that rate.

Note: In the example of a $1,000,000 gain on sale stemming from a reinvestment of $660,000 of corporate profits, the $660,000 of corporate profits gets taxed with twice and the other $340,000 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 as compared to the first set.

The Reality Sandwich for Business Owners

The politicians and media pundits who debate such things can argue about the fairness of tax rates in the preceding example cases.

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% or 20%. Yes, the taxes paid on the individual tax return might equal 15% or 20%. 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% or 20%.

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.

Rules Differ for High-income Taxpayers

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, for example, the Affordable Care Act (aka Obamacare) levies a new 3.8% Medicare surtax on the qualified dividends and capital gains when a taxpayer's income rises above $200,000 (above $250,000 if married filing joint). If you actively participate in running an S corporation, however, the Medicare surtax doesn't apply to your S corporation profits. Bottomline? The Affordable Care Act makes the case for S corporations stronger.

Second, starting in 2013 individuals making more than $400,000 and married taxpayers making more than $450,000 pay a special higher 20% rate (rather than the 15% rate) on long-term capital gains and "qualified" dividends.

With a 34% corporate tax rate, a 3.8 Medicare surtax, and a 20% dividends or capital gains tax rate, the combined federal income tax rate reaches nearly 50%.

Third, 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.

The Bottom Line

Okay, so here's the bottom line: You probably would not pay less tax by running your small business as a C corporation. It's possible. And one ever wants to use the word "never." But the double and triple taxation that's going on when you do a careful accounting of the "S corporation versus C corporation" choice means that choosing to operate as a C corporation would often significantly increase your tax burden.

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