A C corporation opens up several tax opportunities for shareholders/owners in taking money out of their business. Because a corporation is a separate legal and tax entity from its owners, you and your corporation may engage in beneficial financial dealings, such as loans, between each other. This post provides fair guidelines about taking money [just in any possibilities of term: compensations, dividends, loans, leasing, or selling corporate stock] out of a C Corporation. Enjoy!
Compensation for Services On C Corporation
If you work in your incorporated business, you are not self-employed. You are an employee of your corporation, just like the secretary or a bookkeeper of your C Corporation.
Small corporations may benefit from putting the owner/shareholder’s spouse and kids on the payroll. Spreading family business income over lower tax brackets is legal as long as everyone does real work and isn’t overpaid.
In theory, the tax law [rather vaguely] limits the wages you can receive from your C Corporation—salaries and bonuses paid to shareholder-employees must be reasonable. [IRC 162]. Corporations paying unreasonable compensation for personal services can have this wage expense disallowed or reduced during an IRS audit.
Pay attention to corporate formalities; the IRS does. Always prepare corporate minutes or resolutions [records] of corporate financial transactions—loans, compensation of officers, and so forth. IRS auditors often inspect corporate records. If you haven’t kept up your corporate paperwork, an auditor can say you didn’t really have an incorporated business. Then, tax benefits can be disallowed because corporate records books are not up-to-date or state filings for the corporation were not made.
An IRS auditor can also assess a 25% penalty on certain excessive salaries. This penalty applies to officers, directors, and family members of closely held corporations. Also, penalties can be applied if corporate assets are transferred at large discounts instead of cash. [Again, this is not usually a concern for small business corporations.]
Prepare for an IRS audit challenge for unreasonable compensation. Assuming you do significant work for your corporation, draw up an employment contract stating your salary and duties. This shows that your pay was a well-thought-out business decision.
Keep your stated salary fairly consistent from year to year—even if the corporation does not always have enough funds to pay it. Otherwise, if your salary is tied to profits, it looks more like a corporate dividend on your investment, and not wages. If the corporation has a down year and can’t pay your scheduled salary, get a promissory note from the corporation. Then take funds when they’re available in future years as payment on the note. Document shareholder compensation decisions in the minutes of the corporation.
Dividends To Shareholders Of C Corporation
A C corporation may pay dividends to shareholders if it has enough current and retained earnings to also pay its debts. But, this may not make tax sense because the corporation is taxed on its profits before the dividend is paid, and the recipient shareholder is taxed again. When a small corporation pays dividends, it’s usually done for shareholders who don’t work in the business and aren’t paid salaries.
FYI: Lower Tax on Dividends. For individuals, qualified corporate dividends are taxed at 5% to 15% instead of at ordinary income tax rates [which range up to 35%]. For details, see Publication 550, Investment Income and Expenses, or talk to a tax pro to see if your corporation’s dividends qualify for this tax break.
Loans to Shareholders Of C Corporation
A profitable C corporation may lend money to its shareholders. A loan from your C corporation isn’t taxable income to you and doesn’t have tax consequences to the corporation. Interest paid by the borrower on the loan is income to the corporation, of course.
Shareholder loans must be bona fide. The borrowers must promise in writing to repay the loan at a specific date, and the loan should be secured by pledging assets, which will be forfeited if the loan is not repaid.
Corporations can make loans to shareholders of less than $10,000—interest-free. Larger loans must carry a commercially reasonable rate of interest—at least the minimum legal interest rate.
The IRS knows shareholders are tempted to label all withdrawals from their corporation as loans, because loans are not taxable income. So, if a loan doesn’t look legitimate, an IRS auditor can rename it and tax it as compensation or a dividend payment.
Checklist for Loans to Shareholders
A loan to a shareholder should look like a bank loan, to withstand an auditor’s challenge. Plus, the parties must abide by its terms. The corporation shouldn’t give a shareholder any breaks—such as forgiving interest on the loan—that a bank wouldn’t give. Here are the specifics:
- The corporate records should reflect all loans.
- The shareholder should sign a promissory note for a specific amount.
- The note should obligate the shareholder to repay the loan unconditionally on a specific date or in regular installments.
- The corporation should charge at least the applicable federal rate [AFR]. The Treasury Department sets this rate once a month; call the IRS or check the IRS website at www.irs.gov for the current AFR rate. If a corporation doesn’t charge at least this rate, an IRS auditor can attack it as a below market loan [IRC 7872] and the borrower will be taxed as receiving the value of the undercharged interest.
- The note should be legally transferable by the corporation to a third party.
- The loan should be secured by collateral such as a bank account, real estate, or other shareholder property.
- The note should stand on equal footing with debts of others to the corporation.
- The note should give the corporation the right to sue and take the collateral if the shareholder does not repay the loan on time.
- The shareholder should make all interest and principal payments when due.
Leasing Assets to Your C Corporation
Leasing things that you own to your corporation is another way to extract profits—without paying taxes on dividends or employment taxes on salaries. Real estate is most often leased to a corporation by its shareholders, but leasing can also work taxwise for things like equipment or machinery.
Leasing to your corporation can produce a paper loss for you, the shareholder, which you can offset against your other income. Typically, the loss comes from your depreciation deduction on the leased asset. It can also come when cash expenses exceed cash income. Either way, it offsets, or shelters, other income on your individual tax return.
Example: On January 1, Brad buys a building for $100,000. He immediately leases it to his C corporation, Nice Estate, Inc., at the market rate of $12,000 per year. Since the building is worth $80,000 [the lot is worth $20,000], Brad is allowed to take depreciation deductions of $2,051 per year. Brad incurs annual expenses for real estate taxes, maintenance, and mortgage interest on the building totaling $11,400. After applying the rent payments from Nice Estate, Inc., Brad reports a loss of $1,451 on his tax return [$12,000 income – $11,400 expenses – $2,051 depreciation = $1,451 tax loss].
Note: Passive loss rules for real estate may limit Brad’s ability to offset rental losses against other income. [They are beyond the scope of this post, however, so check with an accountant if this may be an issue].
To pass IRS audit muster, a lease between a shareholder and the corporation must be a realistic deal. The lease payment must be close to fair market value. But because rents for similar assets can vary, you can charge your corporation a bit more [or less] than you might get from others. How much depends on several factors. A 25% discrepancy from fair market value is usually defensible—especially if you can back it up with a written opinion from a professional that the rent paid is within the market range.
Example: Alexandra owns a storefront building and rents it to her incorporated bakery business, Sweet Tarts, Inc. The building might rent for $500 a month on the open market, but its size, amenities, and location are unique, making precise valuation difficult. Alexa is probably safe renting it to Sweet Tarts for $625 a month, but $2,000 is not likely to fly at an IRS audit.
Leasing assets limits your liability. A good nontax reason for leasing personal assets to your corporation [rather than having the business own it] is to protect them from corporate liabilities. For instance, suppose your corporation is successfully sued for sexual harassment. The judgment can be collected against the corporation’s property, but your leased assets are safe. Even if the corporation declares bankruptcy, leased property is not a corporate asset; it still belongs to you, its owner.
Selling Your Corporate Stock
A share of corporate stock—a fractional ownership interest in a business—is an asset. As with any asset, its sale means a gain or loss for tax purposes.
Here are the rules:
- Rule-1: Capital Gains – A shareholder’s gain on sale of stock held longer than one year is taxed at a reduced capital gains rate. Example: Rico forms Rico, Inc., and transfers his warehouse to the corporation in exchange for stock. Because of Section 351, the transfer is not taxable. His basis in the warehouse—$75,000—becomes his basis in his stock. Two years later, Rico sells his stock to Linda for $175,000. Rico has a taxable gain of $100,000 [$175,000 minus his basis in his stock of $75,000]. The capital gains tax on Rico’s profit is a maximum of 15% [IRC 1[h]], making his tax liability $15,000. [Rico’s state tax agency will get a cut of the action, too.] Without the capital gains tax rate, Rico’s federal tax could have been as high as $35,000, at a tax rate of 35%.
- Rule-2: Lower Capital Gains Tax – The long-term capital gains tax is now a maximum of 15% for gains on sales of corporate stock held more than one year. And folks in the lower 10% or 15% income tax bracket pay only 5% on long-term gains. For details, see Publication 550, Investment Income and Expenses, or talk to a tax pro.
- Rule-3: Capital Losses – Shareholder losses on the sale of stock face some restrictive tax rules. For instance, unless the corporate stock is qualified under Section 1244, a shareholder’s capital losses can only offset his ordinary income up to $3,000 in any one year. His capital losses may, however, fully offset any of his capital gains.