Three Tax Reasons to Operate as a C Corporation

Small businesses often save taxes by operating as a sole proprietorship, partnership or S corporation--or operating as a limited liability company taxed as a sole proprietorship, partnership or S corporation.

However, even though C corporations may cause a business to pay a second level of tax on business profit, a C corporation may save the small business owner taxes in at least three situations.

C Corporations Allow for Richer Fringe Benefits to Owners

With sole proprietorships, partnerships and S corporations, the tax-free fringe benefits available to owners are very limited. Sole proprietors, S corporation shareholder-employees, and partners may typically deduct health insurance and pension contributions. But not much else.

In comparison, a C corporation can typically provide the same tax-free fringe benefits to owners as it provides to rank-and-file employees. These additional tax-free benefits might include tax-free housing, educational assistance, life insurance--and several other items as well.

A C corporation may also allow a business to provide better healthcare benefits for shareholder-employees. In other words, though this isn't true for sole proprietorships, partnerships and S corporations, a C corporation may be able to discriminate in favor of corporate officers or shareholder-employees and provide them with better or more healthcare benefits.

C Corporations May Minimize Income Taxes on Reinvested Profits

All of the profit of a sole proprietorship, partnership or S corporation gets allocated to the business owner or owners and then taxed on their personal income tax returns. In effect, the last dollars of business profit--money that's probably reinvested in the business--get taxed at the owners' high marginal tax rate.

And that rate can be crushing. The top marginal tax rate on a small business owner can easily be forty or fifty percent when you combine federal and state income taxes and any self-employment taxes. A sole proprietorship, S corporation or partnership may pay as much as $20,000 in income taxes if it reinvests $50,000 of profit in the business.

Modest amounts of C corporation profit, however, get taxed at modest rates. For example, the first $50,000 of a C corporation's profit is typically taxed at rates of 15% to 20%. A C corporation reinvesting $50,000 of profit may pay more like $10,000 in tax.

C Corporations May Reduce Out-of-State Taxes A business that operates in multiple states typically pays taxes not just to its own home but also to the other states where it employs people, holds property or provides services or sells products.

A business pays taxes to all of the states in which it operates because tax laws require businesses to apportion or allocate their business profits among the states of operation.

As a practical matter, though, many small C corporations extract most of all of their business profit in the form of salaries and tax-free fringe benefits. That means a small C corporation typically shows a smaller "left-over" business profit. And less business profit means less state income tax.