Mouse in a Barrel

Like many lawyers I often suggest that clients with a small business, such as a motorsports dealership, incorporate. However, if you incorporate and do not make a special election to be taxed as an S Corporation (where the shareholders pay the taxes on corporate profits) your corporation will be a separate taxpayer known as a C Corporation. A commentator on tax law once compared forming a C Corporation to a mouse jumping into a barrel: easy to get into and hard to get out of.

The problem is this. A successful business starts with a relatively small investment and grows. If you have a C Corporation, all of the profits and growth occur within the corporation. The only way you can take money out of the corporation is to pay taxes on it, either by distributing dividends or paying salary. Salary is deductible to the corporation, but of course taxable to the person who receives it. Dividends are taxable to the recipient at a maximum rate of 15 percent under current law (a rate that is likely to go up), but dividends are not deductible to the corporation. This means that the corporation must first pay taxes on its profits and then the shareholders must pay additional taxes when the remaining money is distributed. This is what is known as the “double tax” on corporate profits.

Distributing earnings may not be the biggest problem however. The big problem is that if and when you want to take appreciated assets out of a corporation, the corporation will be taxed on the distribution as if it had sold the assets. That means it will pay a corporate income tax on the value of the assets in excess of the corporation’s tax basis. Corporations don’t even get a special rate for capital gains; they pay the same rate on capital gains that they would on most other kinds of earnings.

Then when the asset is distributed to a shareholder, the shareholder may have personal recognition of income as well. For example, if the corporation simply dissolves, and the shareholder receives a distribution of all the corporation’s assets in cancellation of his stock, he will have taxable capital gain to the extent that the fair market value of the assets he receives exceeds his cost basis in his stock.

These can be very bad results. If you want to incorporate a business, think about whether you should have an S Corporation instead of a C Corporation. In most states you can also form a limited liability company which has many of the benefits of a corporation, but which is more flexible than even an S Corporation for tax purposes. At least consider these issues before being a mouse that jumps into a C Corporation barrel without thinking about the tax consequences first.

DISCLAIMER: This blog is a highly simplified general discussion. It is not legal advice. Such advice should come solely from qualified legal counsel who understands your situation and who is familiar with all relevant facts, variations in state and local laws that may apply to you, and other matters beyond the scope of this blog.