Surprising C Corps

Today in Tax Notes, Martin Sullivan contributed an interesting article on "small business" C corporations (see "The Small Business Love-Hate Relationship With Corporate Tax").

Sullivan's article mines data in a new study prepared by a group of economists at the Treasury Department. The data indicate that nearly 900,000 small business employers filed tax returns as C corporations in 2007. The thresholds for a "small business employer": gross receipts or total income of less than $10 million; and wage or salary deductions of more than $10,000.

At first blush, the numbers sound pretty crazy. The income of a C corporation is subject to double taxation. Under the "double-taxation dilemma," a C corporation pays tax on its income (the first tax, up to a 35% marginal rate). Then its owners pay tax on dividend payments from the C corporation (the second tax, at a 15% rate for qualified dividends). Including state income taxes, a shareholder of a C corporation may suffer a 55-60% tax expense on income of the underlying business.

For small business owners, the "double-taxation dilemma" is essentially voluntary. And many individual owners of small businesses have elected out. Income earned by "pass-through" entities (e.g., S corporations and partnerships) is subject to a single level of tax. Unlike a C corporation, a pass-through entity does not itself pay tax. Instead, its owners report their share of income from the underlying business, and pay tax on that income (a single tax, up to a 35% marginal rate in 2011).

Sullivan's article explores why small business owners may elect into the "double-taxation dilemma" and operate their businesses through C corporations. Sullivan demonstrates that, "[u]nder the right conditions, a C corporation can be a nice little tax shelter for a small business. That helps explain why so many small businesses remain C corporations when they have the option of becoming LLCs or S corporations."

I follow Sullivan's conclusion. However, I'd guess that many of these C corporations owe their "existence" to bad tax advice or tax illiteracy (i.e., no tax advice). In the M&A context, I've seen numerous instances where a small business owner inadvertently grows a business under a C corporation "wrapper." They come to regret that planning (or lack of planning) when they decide to sell the business. (Due to the "double-taxation dilemma," in most instances, a purchaser will pay more for a "pass-through" entity than a C corporation.) Moreover, most "small" business owners are focused on their small businesses and are resource constrained with no "budget" for tax planning. To this point, Sullivan lists some of the pitfalls for a small business owner seeking to exploit a C corporation tax shelter.

Sullivan's article is worth a read for tax nerds. It encouraged me to jot down some corporate tax reform ideas that have been rattling around in my head. More to come in a subsequent post.