C-Corp Tax Traps
- Double-Tax Structure- The historic disadvantage of the C Corporation entity has been the double taxation. Earnings a first taxed at the corporate level then the dividends that are dispersed are taxed at the shareholder level. For example, if the share holder is subject to the maximum dividend rate of 23.8% then for every dollar that the corporation earns and distributes to the shareholder 39.8% of that dollar will be consumed by federal taxes. Double taxation does not just effect dividends, it also applies to the sale of corporate assets. This can put the selling corporate shareholders in a difficult dilemma either; sell assets and pay corporate and personal income taxes that are roughly 40% of the gain recognized, or sell the stock and take a monetary hit on the share price because the buyer will not get a stepped-up basis on the assets of the business.
- Trapped Losses- Losses incurred by a C-Corp may be carried backward or forward inside the corporation, but the losses can never be passed through to shareholders.
- Locked-In Basis- Basis of a shareholder's stock in a C-corporation is not affected by the corporation's income or losses. This has big consequences for a corporation that has large accumulated earnings, unlike a S-corporation or partnership both of which have the ability to increase the basis in the corresponding interest.
- Redemption Traps- Unless the redemption of stock is structured in a way to be part of the four exceptions under 302(b) of the code, then the full amount distributed in a redemption of the stock is taxed as a dividend to the shareholder to the extent of the corporations profits and earnings. This is particularly important if the shareholder is distributed property that has appreciated in redemption of stock. If a 302(b) exception doesn't apply a situation can arise where the corporation will pay taxes on the built-in gain and additionally the shareholder will pay taxes to the extent of the fair market value of the distributed property. This is a disadvantageous from a tax perspective.
- Disguised Dividend Trap- Payments from the C corporation to shareholders can be scrutinized by the IRS. The issue is what can be deducted at the corporate level. The IRS has declared some common payments to be "disguised dividends" examples include but are not limited to; excessive compensation payments to employees or family members, personal shareholder expenses that are deducted as business expenses, interest payments on shareholder debt that is later classified as equity, excess rental payments on shareholder property rented or leased to the corporation, personal use of corporate assets, and sweetheart deals regarding sales of property from the corporation to a shareholder.
- The 482 Trap- "Section 482 of the code provides authority to distribute, apportion, or allocate gross income, deductions, and credits among related organizations, trades, or businesses if it is necessary in order to clearly reflect the income of such entities or to prevent the evasion of taxes" Rev. Rule. 69-630, 1969-2 C.B 112. Essential this provision allows the IRS to step in when it sees a brother and sister corporation shifting income through "bargain sales," it can have extensive double-taxation consequences.