It’s not uncommon for individuals in higher tax brackets to end up with an undesirable tax bill at the end of the year. It’s also not uncommon for them to be on the lookout for ways they can reduce or eliminate said tax bill through savvy business planning.
In the pursuit of this goal, some may consider following the advice of personalities on social media who suggest creating a C-Corp as a way to shield some of their earnings from a higher rate of taxation. Does this really make sense?
Read on for insight into whether this strategy is wise and the conditions that may apply.
Taxation on C-Corps
We often get questions about whether forming a C-Corp is a “tax hack” that can allow you to accumulate cash as corporate profits while taking advantage of a reduced corporate tax rate that may be lower than the income tax rate for high-earners.
As of 2022, the U.S. has a flat 21% corporate tax rate. Therefore, there’s an idea that keeping earnings inside the C-Corp—as opposed to passing them through to yourself as wages through an LLC or an S-Corp—would result in instant (and potentially significant!) tax savings if you’re in the 37% individual tax bracket.
But there’s a lot more to the situation that you should consider before making a hasty business decision. Specifically, two types of situations may apply: you could run afoul of rules regarding what’s called a Personal Holdings Company or face Accrued Earnings Taxes.
What are Personal Holding Companies (PHCs)?
A C-Corporation can be categorized as a Personal Holding Company (PHC) if it meets the following income and stock ownership requirements:
- The test of income states that passive sources should account for at least 60% of the company’s adjusted ordinary gross income.
- The stock ownership test states that more than 50% of the value of the company’s outstanding stock has been owned (whether directly or indirectly) by five or fewer individuals at any time during the last half of the tax year.
If a corporation ends up being categorized by the IRS as a PHC, it may be liable for an extra 20% tax on its undistributed profits.
What is the Accrued Earnings Tax (AET)?
The Accrued Earnings Tax (AET) is applicable to organizations that are established with the intention of evading income tax by allowing profits to amass instead of properly allocating these earnings.
The AET has a specific purpose: to prevent companies from simply stockpiling cash to avoid income tax burdens for shareholders. As of 2022, the tax rate for accumulated taxable income was 20%.
Avoiding PHC and Accrued Earnings Taxes
If your priority is to avoid the tax on Personal Holding Companies (PHC) and Accrued Earnings Tax (AET), here are some strategies that could help you do so.
Document your business needs
Having at least one documented business rationale for accumulated revenue is one of the most effective ways to prevent this type of taxation.
These kinds of business rationales could include (but are not limited to):
- Debt repayment
- Capital expenditures
- Business acquisitions
- Plans for future growth
Distribute reasonable dividends
Disbursing reasonable dividends that make sense based on profits helps a company demonstrate that it is doing more than just hoarding cash to avoid taxation for shareholders.
Prevent excessive passive income
If a sizable fraction of a business’ revenue is derived from passive sources, it may be worth exploring other business structures or diversifying the company’s income sources in order to minimize the company’s share of passive income (or what the IRS deems “unearned income”).
Regularly review your financials
Another essential way to avoid potentially serious tax issues is to stay ahead of the game by consistently reviewing, evaluating, and organizing the company’s financials and tax positions.
Additional C-Corp tax strategy considerations
Keep in mind that although C-Corps may profit from tax deferral on retained earnings, they also run the risk of double taxation. Dividend payments made from earnings are subject to additional shareholder taxes.
Depending on the situation, this can cancel out part or all of the potential tax deferral benefits of becoming a C-Corp.
Contact a Texas attorney for support
It’s important to scrutinize the financial advice you hear on social media, and if you have doubts or lingering questions, reach out to an experienced business attorney for help navigating business planning and tax concerns.
Based in San Antonio and Austin, Texas, the law firm of Shann M. Chaudhry Esq., Attorney at Law PLLC is deeply committed to our mission of leveraging legal strategy, advocacy, and planning to help your business flourish—and helping you protect the things that matter most to you.
If you have questions about how to structure your business or whether to seek C-Corp status, contact our offices to schedule an affordable consultation today. Our team of service-oriented attorneys is available to hear your concerns, research effective strategies, and recommend an approach customized to your business needs.