A C-Corp can help upper-income taxpayers in business save taxes, but it’s not useful to investors.
Increasingly, upper-income folks and their tax professionals are considering a corporate structure in tax planning in order to avoid Obama-era tax hikes. Starting in 2013, Congress raised the top tax bracket for individuals to 39.6% — effectively 41% after factoring in the Pease itemized-deduction limitation. When the 3.8% Net Investment Tax on unearned income is factored in, the combined individual top rate is a hefty 45%. Upper-income taxpayers are rewarded with an 11% or more tax savings when they can shift income from their individual to corporate tax returns. Plus, Congress is discussing corporate tax reform and they may reduce corporate rates widening the gap with individual rates.
Active traders who don’t qualify for trader tax status (business treatment) wonder if a corporate structure allows trading expense deductions considering that Section 212 investment expenses are restricted on individual tax returns. Corporations cannot deduct Section 212 investment expenses; therefore they don’t provide tax relief when a trader does not qualify for trader tax status.
Businesses can efficiently shift income to a corporation
A pass-through-entity trading business – like an LLC or S-Corp – qualifying for trader tax status has business expense treatment. Administration fees paid to a management company organized as a corporation are a business deduction on the pass-through entity. The receiving corporation has business income and expense treatment.
Business treatment on both the pass-through entity and corporation translates to tax efficiency.
Investors cannot efficiently shift income to a corporation
A pass-through-entity investment company has Section 212 investment expense treatment on the individual owner’s level for administration fees paid to a management company organized as a corporation.
That’s not tax efficient since investment expenses face significant limitations on individual tax returns, including the 2% AGI threshold for miscellaneous itemized deductions and the Pease itemized deduction limitation. Miscellaneous itemized deductions are not deductible for AMT tax.
If the investment company allocates a share of trading gains to the management company corporation in lieu of paying fees, the corporation doesn’t have business purpose. Plus, the corporation could be deemed a personal holding company (PHC) subject to a PHC surtax of 20% on undistributed PHC income. A corporation may not deduct non-business expenses including Section 212 investment expenses, which only individuals may deduct.
Corporations deduct business expenses, not investment expenses
Corporations with business activities may deduct Section 162 trade or business expenses. Corporations aren’t permitted to deduct non-business expenses including Section 212 investment expenses for individuals. When a corporation with established trade or business has ancillary investment expenses related to their business activities — like investing working capital — those expenses are deemed Section 162 business expenses and not Section 212 investment expense. Pure investment companies structured as a corporation may not deduct investment expenses. Pass-through entities with investor tax status report investment expenses on Schedule K-1 issued to individual owners.
Tax law is clear
Our CPA firm researched this tax law: It’s clear Section 212 is for individuals only, and corporations need business purpose to deduct Section 162 business expenses. Corporations cannot deduct non-business expenses. I spoke with an IRS official on this matter and his informal advice was to agree with the position stated in this blog.
Here are some excerpts from highly respected tax publication Bittker and Eustice on “Corporate Deductions.”
- “The Code allows individuals to take a number of deductions that are not allowed to corporations, including the standard deduction, (investment expenses)…. (the code) prevent restrictions aimed primarily at individuals from being sidestepped by a transfer of the restricted activities to a closely held corporation…Section 212 is restricted to individuals, however, presumably on the theory that § 162(a) covers the same ground for corporations that § 162(a) and 212 in combination cover for other taxpayers. Thus, if a corporation engaged in manufacturing holds some securities as an incidental investment, the cost of a safe-deposit box, investment advice, bookkeeping, and so forth incurred with respect to the securities would be deductible under § 162(a) as trade or business expenses, even though an individual proprietor holding such securities would have to resort to § 212 as authority for deducting such expenses.”
Warning to traders not qualifying for trader tax status
Traders not qualifying for trader tax status should not use a corporation since they don’t have business purpose and corporations can’t deduct non-business expenses. While a corporation starts off with presumption of business purpose, that alone doesn’t achieve business purpose. The corporation must qualify for a trade or business. For a trader that means qualification for trader tax status. A corporation is not a remedy for not qualifying for trader tax status.
Corporate tax rates are materially lower than individual rates
The corporate tax rate starts at 15% on the first $50,000 of income, 25% on the next $25,000 and it settles in at 34% thereafter. Personal service companies don’t qualify for the lower rates under 34%. Taxpayers generally try to take advantage of the lower bracket rates so if the corporation pays them qualified dividends years later there’s still meaningful cumulative tax savings.
Unlike pass-through entities including S-corps, LLCs and partnerships, a corporation (C-Corp) pays entity-level taxes. (Note: LLCs can also elect C-Corp tax-filing status.) An individual owner pays taxes on qualified dividends paid by the corporation up to a 20% (long-term capital gains) rate. Plus a 3.8% NIT is applied on unearned income if you’re over the AGI threshold. Paying taxes on the entity and individual levels is commonly referred to as “double taxation.” Corporations avoid double taxation by paying compensation to owner/officers. Most states also tax corporations, so double taxation can defeat the purpose of using a corporation in high tax states. (State taxation for corporations is beyond the scope of this blog post; see more information in Green’s 2015 Trader Tax Guide.)
A corporation needs business purpose
Before you jump into reorganization as a corporation, it’s important to understand the pros, cons and potential pitfalls. My bailiwick is investors, traders and investment managers. In a nutshell, adding a corporation as a second entity makes sense for a business trader or investment manager to reduce Obama-era tax hikes on individuals. But using a C-Corp structure for an investment company does not work. Corporations need a business purpose; therefore, investors won’t find salvation using a corporate structure.
A successful strategy for a trading business
Suppose you have a successful trading company LLC that qualifies for trader tax status and files as either a S-Corp or partnership. Consider adding a corporation as a second entity to provide administration services or to hold intellectual property and charge royalties to the trading company LLC. That has the effect of shifting income from your individual tax return to a corporate tax return. Either the S-Corp trading company or C-Corp management company can unlock employee-benefit plan deductions including health insurance and retirement plans. (Investment companies can’t generate compensation or earned income by arranging employee-benefit plan deductions.)
A failed strategy for an investor
Suppose you have an investment activity that doesn’t qualify for trader tax status (business treatment). (Read How to Qualify.) You also don’t offer investment management services to clients, so you don’t have any business purpose.
A tax salesman approaches you and promises tax deductions using a corporation. These promoters find their prey on the trading education and seminar circuit. The promoter says you can dump your education expenses and other startup expenses into a corporation going 18 months back and generate a net operating loss (NOL) in the corporation to carryover to subsequent tax years. The promoter also suggests a second LLC entity for trading.
If that LLC doesn’t qualify for trader tax status and pays the corporation management or administration fees, it will have investment expense treatment. That defeats the purpose and you’re right back at the beginning of the problem with investment expense limitations on your individual tax return. Seminars and pre-business education are generally not deductible as investment expenses pursuant to Section 274(h)(7).
Conversely, the LLC can wait to achieve trader tax status at a later date and pay the corporation fees then, which will be business deductions for the LLC trading business. The promoters argue the corporation can utilize its NOL to offset the income from the trading business LLC. But, that doesn’t work in my view, as the corporation can’t deduct those expenses in the first place without business purpose from its inception. Dumping expenses that lack deductibility into a corporation for later use does not have legal authority.
At best, the corporation is entitled to capitalize Section 195 startup business expenses for a reasonable amount over a reasonable period if it has business purpose in the works. It’s simple for an IRS agent to determine whether a corporation has trader tax status or business revenue and, therefore, to determine whether any expenses are legitimate Section 162 corporate deductions.
Personal holding company taxes
Corporate structures are intended for trade or business, not investment companies. Personal holding company (PHC) law charges additional taxes on corporations straying into non-business activities. There are exceptions from PHC rules for financial institutions including banks and insurance companies, but that list doesn’t include trading companies.
The PHC tax is 20% of undistributed personal holding company income. PHC income (Section 543) includes dividends, interest, royalties (with exceptions), annuities, rents, personal service contracts (with exceptions) and more. Exceptions from PHC income include active business computer software royalties, active business copyright royalties in many fact patterns and personal service contracts when a specific person (talent) isn’t named in the contract (consult a tax expert). PHC income also does not include capital gains on trading, which is the main source of income in a trading company. PHCs are corporations with five or fewer owners and more than 60% of their income is from PHC income. The definition of PHC Section 542 discusses business deductions and it clearly leaves out Section 212 investment expenses (which are for individuals not corporations).
The tax code is written to prevent individuals from skirting the narrow Section 212 investment expense deduction rules. Schemes to dump these expenses into corporations are poorly conceived and will lead to tax trouble.
Business traders and investment managers paying top Obama-era tax rates should consider adding a corporation to the mix for legitimate tax savings.
Green NFH CPA Darren Neuschwander and tax attorney Roger Lorence contributed to this blog.