The Successful C Corporation Owner's Tax Blunder

Business owners often assume that a traditional corporation, or "C corporation," provides a good platform for saving money and growing wealth. As a result, these individuals do their investing inside their C corporations.

Superficially, this wealth-building opportunity seems logical. Profits retained inside the small business C corporation will typically be taxed at a low 15% corporate tax rate. So the entrepreneur gets to save as much as 85% of the pre-tax profits.

In comparison, if a C corporation pays out its profits to owners as dividends or large shareholder salaries, the profits often get taxed at rates of 40% or more. In the end, the entrepreneur saves at most 60% of the pre-tax profit.

Despite the attraction of investing 85% of your pre-tax profits inside a C corporation instead of 60% or less of your pre-tax profits outside a C corporation, this particular gambit is a terrible idea for four reasons ...

C Corporation Tax Issue #1: No Preferential Capital Gains Tax

The first problem with building wealth inside a C corporation concerns the long-term capital gains tax rate that the C corporation pays on its investment profits.

Specifically, here's the rub: A C corporation's long term capital gains don't get treated favorably. C corporation capital gains are treated and taxed as regular income. A business that is successful in its investing, therefore, might easily pay a 35% or 40% capital gain tax.

In comparison, individuals currently pay a much lower 15% long-term capital gain tax. And even though politicians are talking about raising the long-term capital gains tax to 20%, that's still way less than the rate a C corporation might pay.

To summarize, then, saving and investing inside a C corporation means paying capital gains taxes that are 2-3 times what as an individual pays. Ouch.

C Corporation Tax Issue #2: Double Ordinary Income Taxation

The lack of a preferential long-term capital gains rate isn't the only problem with investing inside a C corporation, unfortunately. Another big problem exists--the prospect of double ordinary-income taxation.

Here's how this works. Suppose a business owner does inadvertently save and invest inside a C corporation. And then in a few years the business liquidates the investments--and of course pays perhaps a 35% to 40% income tax.

If the C corporation then disburses the profits to the shareholders and the Bush tax cuts have expired in 2010 (as seems likely), the dividends will be taxed at ordinary income tax rates. Shareholders, in other words, might pay up a second, 40% tax when they receive the dividends.

This double ordinary income taxation may mean taxes take 60% or more of the investment profit when investing inside a C corporation. Yikes.

C Corporation Tax Issue #3: Capital Loss Usage Limitations

But you need to look at more than just tax rates when thinking about investing inside a C corporation. You should also consider what happens when investment losses occur. Here's why: Capital losses that occur inside a C corporation are more difficult to use as a deduction.

If an individual suffers a capital loss, for example, the individual can net the capital loss against capital gain in the year the loss occurs. Then the individual can use up to $3000 of any leftover capital loss to offset ordinary income in the year the loss occurs. And then the individual can carry forward any remaining capital loss to future years to wipe out capital gains and up to $3000 a year of ordinary income in those years.

The rules for using capital losses on an individual tax return are a little complicated, obviously. But at least the individual taxpayer probably gets to use the losses eventually.

Inside a C corporation, however, capital losses work differently. First, capital losses can only be netted against capital gains. Second, capital losses don't just "hang around" indefinitely.

A corporation can carry a capital loss back three years, and apply the capital loss to gains in those years. And a corporation can carry a capital loss forward five years, and apply the capital loss to gains in those years. But any leftover capital loss which still exists after the three-year carry-back and five-year carry-forward is then forgotten.

As compared to C corporations, obviously, individuals benefit from more forgiving capital loss usage rules.

C Corporation Tax Issue #4: Deemed Exchanges Upon Distribution

Finally, one important point of clarification. Sometimes business owners, upon learning about the headaches of C corporation investing, decide to just withdraw the investments from the C corporation. For example, a C corporation that rather foolishly decided to buy the building the firm uses might decide to just give the real estate to the shareholders.

That would seem to solve the problem, right?

Well, no, unfortunately. And here's the reason: If a C corporation distributes property to shareholders, tax laws effectively say that the property was sold by the corporation at its fair market value and then the implicit proceeds paid out as a dividend to the shareholders. This deemed exchange treatment means that the C corporation and shareholders still pay all those taxes described in the preceding paragraphs.

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