C Corporation Owners – Double Taxation
“Double Taxation” – great for tax collector, less so for tax payer – refers to C Corporations (“C-corp”) being considered distinct and separate from the shareholders for tax purposes. C-corps pay taxes on net income, whereas S-corporations (“S-corp”) or LLCs “pass through” tax obligations to shareholders or participants. For S-corps and LLCs, profits can be distributed to the owners in a tax efficient manner in that there is only the one tax at the individual level. For C-corps, after profits are taxed, distributions to shareholders – dividends – are taxed at the individual level, thus the “double tax.” If you are operating as a C-corp, there are nuances to be aware of that may rear their ugly selves come sale time. Sellers beware.
Be mindful of payments to shareholders (i.e., salary, bonus, dividends), as the IRS is. A buyer or investor will diligence these payment practices to make sure the IRS doesn’t come knocking post transaction. A deal announcement shines a spotlight on your company, and may generate more attention from regulators than when you’re just another operating company. Reasonable salary and bonuses for shareholders involved in day-to-day operations avoids double taxation from a cash perspective; albeit there is downside since tax rates on dividends are lower than W-2 income. In addition, there is a fine line between what is “reasonable” that owner / operators must navigate due to subjectivity. A few guidelines to consider include the individual’s qualifications, level of involvement and pertinence to daily operations, current economic conditions, complexity of the business, other employees’ compensation, and compensation of similar positions at comparable companies, amongst others. The IRS looks to ensure that compensation is suitable for a respective role and responsibility, and not a “disguised dividend” to avoid double taxation by maximizing pre-tax cash distributions. These guidelines are similar to those discussed with respect to S-corps in our July 11th blog, but with different focus and consequence.
While the thought of a potential dispute with the IRS may convince many owners to err on the side of conservatism, the mix of dividends to salary / bonus has significant tax implications. Working closely with a tax accountant to determine a justifiable and well-documented determination of owner compensation will provide ease of mind while maximizing take-home pay.
Contributors: Marc Marlin and Robert Dowling