When taking into account the Tax Cuts and Jobs Act for 2018, don’t focus solely on the federal 21% flat tax rate on the C-Corp level. There are plenty of other taxes, including capital gains taxes on qualified dividends, state corporate taxes in 44 states, and accumulated earnings tax assessed on excess retained earnings.
When a C-Corp pays qualified dividends to the owner, double taxation occurs with capital gains taxes on the individual level (capital gains rates are 0%, 15% or 20%). If an owner avoids paying sufficient qualified dividends, the IRS is entitled to assess a 20% accumulated earnings tax (AET). It’s a fallacy that owners can retain all earnings inside the C-Corp.
C-Corp vs. individual tax rates
Starting in 2018 under the new tax law, C-Corps may benefit from a 21% flat tax rate vs. individual graduated rates of 10% to 37%. Don’t confuse your tax bracket with your tax rate, which is less. For example, the average individual tax rate is 27% for a married couple entering the top 37% tax bracket of $600,000 and 30% for a single filer approaching the top bracket of $500,000; so the actual rate difference is 6% and 9% in these two examples.
Upper-income traders may also have individual 3.8% net investment tax (NIT) on net investment income (NII). NIT applies on NII over the modified AGI threshold of $250,000 (married) and $200,000 (single). Adding this in, the difference between the flat rate could be 9.8% and 12.8% in our example.
Traders don’t owe self-employment (SE) tax, so I don’t factor that into the equation. Other small business owners have SE or payroll tax in pass-throughs but can avoid it with a C-Corp. Let say the C-Corp has a 10% rate advantage for high-income traders and a lower or no benefit for middle- to lower-income traders.
Now come all the haircuts that can lead to adverse taxes and make the C-Corp a costlier choice for a trader. Double taxation on the federal level can wipe out that savings with a 15% or 20% capital gains tax on “qualified dividends.” Double taxation on the state level can lead to a C-Corp owner paying higher taxes than with a pass-through entity. There are potential 20% accumulated earnings taxes and personal holding company tax penalties. Look before you leap into a C-Corp and consult a trader tax expert.
C-Corp double taxation with qualified dividends
A C-Corp pays taxes first on the entity level, and the owners owe taxes a second time on the individual level on dividends and capital gains.
When C-Corps make a cash or property distribution to owners, it’s a taxable dividend if there are “earnings and profits” (E&P). If the individual holds the C-Corp stock for 60 days, it’s a “qualified dividend,” subject to lower long-term capital gains rates of 0%, 15%, and 20%. The 0% capital gains bracket applies to taxable income up to $77,200 (married) and $38,600 (single). A 15% dividends tax offsets the difference in individual vs. corporate tax rates.
State double taxation can ruin the C-Corp strategy
According to Tax Foundation, “Forty-four states levy a corporate income tax. Rates range from 3 percent in North Carolina to 12 percent in Iowa.” (See your state on the Tax Foundation map, State Corporate Income Tax Rates and Brackets for 2017.) States don’t use lower capital gains rates for taxing individuals; they treat qualified dividends as ordinary income.
A C-Corp is a wrong choice for a trader entity in California with an 8.84% corporate tax rate, but it could be the right choice for a high-income trader in Texas without corporate taxes if he or she retains earnings and can successfully avoid IRS 20% accumulated earnings tax (more on this to come). The Texas 0.75% franchise tax applies to all types of companies with limited liability, including LLCs, and C-Corps, and the “No Tax Due Threshold” is $1.11 million. Most traders won’t trigger the Texas franchise tax.
Don’t try to avoid filing a C-Corp tax return in your resident state. You are entitled to form your entity in a tax-free state, like Delaware, but your home state probably requires registration of a “foreign entity,” if it operates in your state. Setting up a mail forwarding service in a tax-free state does not achieve nexus, whereas, conducting a trading business from your resident state does.
The new tax law capped state and local income, sales, and property taxes (SALT) itemized deductions at $10,000 per year. It does not suspend SALT deductions paid by C-Corps, but that expense is only the double-taxed portion; the individual SALT on qualified dividends is still limited.
Accumulated earnings tax
If the C-Corp does not pay dividends from E&P, the IRS can assess a 20% “accumulated earnings tax” (AET) if the C-Corp E&P exceeds a threshold and company management cannot justify a business need for retaining E&P. The IRS is trying to incentivize C-Corps to pay dividends to owners. The IRS AET threshold is $250,000, or $150,000 for a personal service corporation. (See Section 533.)
If the IRS treats a trader tax status (TTS) trading company as an “investment company,” then it may assess 20% AET on all E&P and therefore undermine the C-Corp strategy for traders. But I don’t think a TTS trading company with Section 475 ordinary income is an investment company. A TTS trading C-Corp needs to demonstrate a business need for E&P above the $250,000 threshold.
“AET requires the corporation to have adopted a plan for business expansion that will require substantial additional capital,” says Roger Lorence, a tax attorney in the New York City area who specializes in hedge fund tax. “The plan must be in writing and adopted by the Board; it must refer to the analysis of the business, the need for expansion, the need for more capital, and include a timeline for implementation.”
Arguing the C-Corp needs more trading capital for growing profits is likely not an acceptable reason for avoiding dividends. Sufficient reasons might include buying exchange seats, hiring traders and back office staff, and purchasing more equipment and automated trading systems. Over a period, the C-Corp must implement its formal plan. Otherwise, the IRS won’t respect the policy. Many one-person TTS trading companies don’t have these types of expansion plans, and they likely won’t succeed in defending against an AET assessment. Previously, I pointed out a C-Corp might be suitable for a high-income trader, but they would probably exceed the AET threshold in the first year.
Personal holding company tax penalty
“Personal holding company” (PHC) status is triggered when a closely held C-Corp has at least 60% of gross income coming from certain passive income (including interest, dividends, rents, and royalties), and has not made sufficient distributions to shareholders. The IRS is entitled to assess a 20% PHC tax penalty. The new tax law did not revise the PHC rules, and some tax experts think Congress should have tightened them.
Capital gains and Section 475 ordinary income are not passive income, so a successful TTS trader C-Corp will likely not meet the definition. However, if a trader incurs a net trading loss for a given year, then passive income might exceed 60% of gross income and trigger a PHC penalty. If a trader has substantial passive income, don’t hold those positions in a C-Corp.
Officer compensation avoids double taxation
Historically, C-Corps paid higher officer compensation to avoid the 35% C-Corp tax rate. But now, C-Corps may want the 21% C-Corp tax rate over the individual tax rates up to 37% on wage income instead.
1. No lower 60/40 capital gains tax rates on Section 1256 contracts.
2. Ordinary losses do not pass-through to the owner’s tax return, missing an opportunity for immediate tax savings against other income. The new law has an excess business loss limitation of $500,000 (married) and $250,000 (single), and it repealed the NOL carryback, only allowing carryforwards.
3. A C-Corp investment company without TTS may not deduct investment expenses. The Act suspends miscellaneous itemized deductions for individuals, which includes investment expenses. Don’t try to house investments in a C-Corp; it might be deemed a PHC.
4. If you liquidate a C-Corp to realize the capital loss and ordinary loss trapped inside it, you might qualify for Section 1244 ordinary loss treatment up to $100,000 (married) or $50,000 (single), with the remainder of the loss treated as a capital loss. Therefore, you could be stuck with a capital loss carryover. Per Section 1244, “a corporation shall be treated as a small business corporation if the aggregate amount of money and other property received by the corporation for stock, as a contribution to capital, and as paid-in surplus, does not exceed $1,000,000.” Conversely, with a pass-through entity and Section 475 ordinary loss treatment, the trader would have all ordinary loss treatment.
There are a few good things about C-Corps: A more extensive assortment of fringe benefit plans for owners, and charitable contributions, which some individuals may limit due to the higher standard deduction.
Example: Profitable trader in a tax-free state
Nancy Green, a resident of Texas, consistently makes well over $500,000 net income per year trading securities with Section 475 ordinary income. She has officer compensation of $146,000 to maximize her company Solo 401(k) retirement plan contribution of $55,000 (under age 50).
With an S-Corp, her 2018 gross income is $646,000 ($500,000 K-1 income and $146,000 wages), she takes a $25,000 itemized deduction, which makes her taxable income $621,000. Nancy is over the $207,500 taxable income threshold for a specified service activity, so she does not qualify for the Act’s 20% deduction on qualified business income (QBI) in a pass-through. Her 2018 federal income tax is $195,460. Her marginal tax bracket is the top 37% rate, and her average tax rate is 31% — 10% above the C-Corp flat rate of 21%. She also owes 3.8% NIT on $300,000 ($500,000 K-1 income less the modified AGI threshold of $200,000), which equals $11,400. Nancy’s total federal tax liability using an S-Corp is $206,860.
With a C-Corp, Nancy’s individual tax return gross income is $146,000 from wages, and she takes a $25,000 itemized deduction, which lowers her taxable income to $121,000. Her individual federal income tax is $23,330, which is 19.3% of taxable income. Nancy does not owe NIT in this case. (This assumes she has no qualified dividends from the C-Corp.) The federal corporate tax is $105,000 ($500,000 times 21%). With her individual tax paid using the C-Corp, her total federal tax is $128,330.
The C-Corp structure delivers 2018 federal tax savings of $78,530 vs. the S-Corp. There is no corporate or individual income tax in Texas, and she did not exceed the franchise tax threshold, so the savings with the C-Corp can be significant. It also depends on whether or not she pays qualified dividends or has an IRS 20% AET assessment.
If Nancy needs distributions for living expenses, she has two choices:
1. Pay additional wages, which only are subject to Medicare tax of 2.9%, reducing C-Corp net income at a 21% rate, and subjecting her to more individual tax at 24% and 32% marginal rates. (This might be the more attractive option.)
2. Pay qualified dividends taxed at 15%, plus some 3.8% NIT, which does not reduce C-Corp taxes. Her overall savings will decline, but it’s still substantially positive vs. the S-Corp. For example, a qualified dividend of $300,000 would cause $45,000 of capital gains taxes and $9,348 of NIT. Net federal tax savings from using the C-Corp vs. the S-Corp would be $24,182.
If Nancy moves to California, the C-Corp is not a good idea because California has an 8.84% corporate tax rate and with double taxation, the C-Corp savings disappears. Like many other states, California treats all income as ordinary income; it does not distinguish qualified dividends or long-term capital gains. In Nancy’s case, California’s corporate tax would be $44,200 ($500,000 x 8.84% rate), plus individual taxes on $300,000 qualified dividends would be approximately $28,000. A C-Corp in California would lead to much higher federal and state taxes vs. using a dual entity solution, where a trading partnership and S-Corp management company are used to avoid the state’s 1.5% franchise tax on S-Corps.
The 800-pound gorilla in the room is the 20% accumulated earnings tax (AET), and under what conditions the IRS may assess it on a trading business C-Corp. Nancy can tell the IRS she is a TTS trader entitled to retain earnings up to $250,000. Her C-Corp made $500,000 and paid qualified dividends of $300,000, so she kept $200,000 of profits inside the C-Corp. The IRS allows up to $250,000, so she should be fine for 2018, but what about 2019? Does Nancy have a written plan that is feasible for keeping a war chest of earnings over the $250,000 threshold? Probably not, and that could render the C-Corp tax advantage a mirage for her and others in a similar boat.
I suggest traders consult with me to discuss their 2018 projections and see which shoe fits best: a partnership, S-Corp or C-Corp, or some combination, thereof.