The one thing certain is change this next year. And likely that change will extend to your tax planning. If you have a business, there is a change you need to watch very carefully.
Done right, you could pay a whole lot less in taxes.
There is one thing that both Pres-Elect Trump and Kevin Brady agree on with their tax plans: C Corp tax rates have to come down. Actually, this was also something that Pres Obama had said as well.
Why? Our C Corp tax rates are just too high in comparison with other industrialized nations. In fact, ours are the highest.
Trump’s plan calls for lowering the tax rate from 35% to 15%. Brady calls for lowering the tax rate from 35% to 20%. However, the House bill (Brady’s bill) has a couple of other notable differences. For example, the cost of capital investment will be fully and immediately deductible.
Under 2016 tax law, there are two times when a C Corporation might make sense for a US Taxpayer. Of course, you need to have a legitimate business in each case.
(1) There are significant tax free benefits that the owner wants to take. The biggest would be a MERP (medical expense reimbursement plan). This allows a company to take a 100% deduction for all medical, vision and other qualifying expenses, directly against corporate profit. It is not a Sec 125 or other payroll type plan. The MERP is much more flexible and easier to maintain.
If you don’t have other full time employees and have a lot of medical expenses, a C Corporation could be a good solution, even without the possible changes.
(2) The second time when a C Corporation might make sense under 2016 law is if your income is at the highest personal tax rate, or approaching that. The first $50K of a C Corp’s taxable income is taxed at just 15%. So, if you are able to add a C Corporation in addition to your flow through entity (partnership or S Corporation) income, you’d move from 39.6% to 15%, for a savings of $12,500 per year in federal tax.
The challenge with a C Corporation is that under current law, the tax bracket rates climb quickly from that initial 15% to 35% as the taxable income increases. At 35%, it stops making sense to have a C Corp. The other issue is the question of how you get the money out of the corporation.
If you pull it out in salary, it’s a deduction for the corporation but income for you. You’ve just defeated your purpose to move income from your personal return to your corporation.
If you take dividends, that’s even worse. It’s not a deduction for the corporation but it is income for you on your personal return. That’s where the expression “double taxation” comes from.
If you take tax free benefits, that’s the best of all worlds. It’s a deduction for the corporation and not taxed at your personal level. But there is a limit on benefits. They have to be a legal tax-free benefit and once you’ve maxed those out, then what?
New C Corp Plan
Once we see the maximum C Corp tax rate drop from 35% to 15% – 20%, one of the biggest challenges to C Corps as just gone away. The House (Brady) plan also calls for the dividend tax rate to get cut in half. So, if you’re at the new highest 33% tax rate, you’ll pay only 16.5% tax on dividends. That means the penalty for paying dividends from your C Corporation has been reduced. I still don’t recommend it, especially if this is a small, family C Corporation, but if you do have to pay it, the downside isn’t as bad.
Of course, we have to wait to see what the final tax law ends up being, so you may want to build some flexibility into your plan.
Don’t operate strictly out of a C Corporation. Filter through an operating S Corp or LLC taxed as an S Corp first. Then set up an LLC for the C Corp, but don’t immediately elect to be taxed as a C Corp. You can make a late election later in the year once you know for sure what the tax laws will actually be.
Right now, your job is to set up for flexibility so you can quickly act on tax changes and educate yourself so you don’t have to get up to speed with education and analysis when there isn’t much time to act.
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