Understanding C-Corporations in New York
A C-corporation is treated as a separate entity for federal and New York State tax purposes. The corporation pays taxes at the federal level and depending on the jurisdiction of where it is formed and operating state and local taxes as well. In addition, payments to shareholders may be taxed as dividend payments. At MEDOWS CPA, PLLC we have a great deal of experience in handling of the accounting and tax preparation for C-corporations in New York. Below, please find a highlight of issues that pertain to a many of our C- Corp clients.
Taking Money from C Corp
Your business may have reached the point of such success that you want to start taking more money out of it. The owner of a business run as a corporation can simply have the company declare a dividend, which would be payable to the owner and any other shareholders. However, this route bears a heavy tax cost. The company will have already been taxed on the earnings used to pay the dividend, and you will be taxed on its receipt. Fortunately, there are other ways of taking money out of a business at a much lower tax cost.
Some steps can be taken to produce immediate tax savings. Other efforts will reduce taxes down the road. Also, there may be opportunities to get business funds in the hands of family members at a lower tax cost than would result if the funds were paid directly to the owner.
Maximum savings per dollar can be realized when the business makes expenditures that benefit the owner, are deductible by the business and are not taxable to the owner. Lesser but still good savings can be realized for business expenditures that benefit the owner, are deductible by the company and are either taxed in a favorable manner to the owner or are tax-deferred. Some items that the business may legitimately deduct may be only partially taxable to the owner or may not be subject to social security taxes. Many valuable fringe benefits fall into these categories and can produce substantial savings.
Even distributions or expenditures that are fully taxable to the owner may be better than dividends, if the company can deduct them. For example, a dividend paid by a C corporation in New York is not deductible by it and is taxable to the shareholder. If that same amount could properly be paid out to the shareholder as compensation, it would still be taxable to the shareholder but at least the company would get a deduction.
Similarly, distributions that are not deductible by the company but that are taxable to the owner as capital gain usually are preferable to nondeductible distributions that are taxable to the owner as ordinary income.
Exactly what tax-favored ways may be used to take money out of a particular business depend on the exact nature of the business, its structure and other factors. Feel free to contact our C-Corp CPAs in Manhattan for more information.
Compensation of Key Employees
Clearly, one of the most important factors in attracting and holding key employees is your company’s program for compensating executives. Naturally, the basic salary is of great importance, but equally important may be special plans of incentive compensation; plans for allowing executives to participate in the ownership of the company through stock options, stock bonuses and other stock-acquiring arrangements; and special plans for deferring compensation. For this reason, many special devices have been developed to compensate the executive.
There are four basic types of benefits currently in use for compensating the executive. These are direct compensation, “perks” or non-cash fringe benefits, deferred compensation, and retirement plans. There are basic differences among these four major types of executive compensation, including their respective tax implications for you, as the employer, and the employee.
Direct compensation. As its name implies, direct compensation is comprised of immediate pay to executives in the form of salary, cash bonuses and qualified stock bonus plans. Direct compensation differs from fringe benefits in that it typically involves cash payments or other evidences of indebtedness to the executive that can be readily negotiated or sold for cash. Direct compensation also differs from deferred compensation and retirement plans in that its impact is immediate (or within a year’s time) rather than delayed until some future date. Generally, executives must recognize income in the year they receive direct compensation, and employers can deduct corresponding amounts in the year they pay direct compensation.
“Perks” or non-cash fringe benefits. Perks are those benefits that most employees think of as being fringe benefits. Thus, the perks that an employer may provide its employees consist of such non-cash benefits as company cars, exercise facilities and employee cafeterias. In the context of executive compensation, however, directors, officers, and managers have come to expect perks “above-and-beyond” those available to the average employee. Therefore, many companies have developed executive perks that consist of such “extra” benefits as chauffeured limousine services, use of corporate stadium skyboxes, and expenses-paid attendance at trade or professional conventions.
Perks tend to differ from direct compensation in that they typically involve the use of employer-provided facilities or reimbursement of employer-induced expenses rather than the payment of cash or its equivalent. Like direct compensation and unlike deferred compensation and retirement benefits, perks provide an immediate economic and financial benefit to participating employees.
Of the four types of executive compensation, perks have been most severely affected by changes in the tax law. Basically, the Internal Revenue Code now provides that all perks are taxable as wages to participating employees unless the perk is specifically exempted from taxation.
Deferred compensation. Deferred compensation refers to what would otherwise be direct compensation or a perk (i.e., fringe benefit); except that it is so structured as to postpone receipt of a portion of an executive’s taxable compensation until sometime after it has been earned by the executive. Conceptually, deferred compensation plans are a type of benefit located midway between the immediate benefits bestowed on an executive by perks and the long-range benefits bestowed under a retirement plan.
A common aim of a deferred compensation plan is to shift otherwise taxable compensation into a future year and, thus, defer, if not reduce, the income tax that would otherwise be paid to the IRS. For example, the deferral of income may be for a fixed period of time or until the executive has satisfied obligations to the company. Deferral of taxable gain will depend, however, on whether a specific provision in the tax code permits such deferral relative to a given form of deferred compensation and upon what conditions. Types of deferred compensation include deferred bonuses, stock options, and the so-called golden parachute payments.
Retirement plans. The term “retirement plan” refers to deferred compensation that takes the form of an employer-sponsored plan or program the purpose of which is to accumulate funds that will be paid to participating employees at some future date (e.g., at retirement or separation from the employer’s service). Retirement plans take many forms (e.g., pension plans, profit-sharing plans and simplified employee pension plans), and there is some latitude permitted as to the benefits that a retirement plan may provide to participating employees. Other than direct compensation, retirement plans are the most costly for employers to establish, maintain and fund. Retirement plans may also be the most important benefit that employers can provide to their employees due to their long-range economic and financial effect on the well-being of the employees. However, retirement plans lose favorable tax treatment if they do not meet nondiscrimination rules. Therefore, few, if any, such plans are designed to provide executives with special treatment or benefits.
Considering the importance of a quality compensation plan to retaining key employees, it is essential that a plan be well thought out. For more information, contact a NYC CPA at MEDOWS CPA, PLLC.
Taking High Compensation Without Dividend Danger
As the owner of a closely held C corporation, you know that your company’s earnings are theoretically exposed to a double tax. Earnings are first taxed to the corporation and those that are distributed to you as dividends are taxed on your individual income tax return, without the company getting a deduction for the payments.
On the other hand, the company can deduct the salary it pays you. While you have to pay tax on the salary, unlike dividends, salary is taxed only once. And while dividend income is taxed as net capital gains rates (at a maximum 20 percent rate if all income exceeds a $457,600 threshold for joint filers, $406,750 for single individuals), that is an additional 15 or 20 percent that you may not otherwise have to pay with proper compensation planning. What’s more, dividend income starting in 2013 is now also subject to the 3.8 percent Net Investment Income (NII) surtax if an individual’s overall income exceeds a $250,000/$200,000 level.
Does this mean that the double tax can be avoided simply by increasing your salary rather than by paying dividends? No, there are two potential problems with that approach. First, the company can only deduct reasonable compensation. Second, if compensation is set at the high end of the scale and is later found to be unreasonable, the IRS can charge the owner with a constructive dividend on the unreasonable portion of the compensation.
What then can be done? Proper planning can maximize the amount of compensation the company can pay in a way that will increase its chances of being able to withstand an IRS challenge.
The basic test of reasonableness, as applied by the IRS and many courts, is whether the amount paid is analogous to that paid by employers in like businesses to equally qualified employees for similar services. In this respect, the total compensation package is examined including contributions to retirement plans and other employee benefits.
As a result, a showing of special skills may help to justify reasonableness. It also can be helpful if the individual performs different roles for the company (for example, chief executive officer and designer of a new product).
Another possible approach may be to set up a portion of an owner’s compensation to be paid as bonuses if profits meet certain levels. While the IRS has attacked such contingent compensation arrangements in family companies, some courts have upheld them where the agreement was set up when the business was started or when the amount of the future earnings was questionable, and the agreement was consistently followed during the ups and downs of the business.
Few businesses start out with the owners able or willing to pay themselves what they are really worth. Even after the business is successful, periods of economic slowdown, may force belt tightening. It is in these situations that an owner may have an opportunity to enter into a formal contract with the company calling for a share of the profits as added compensation when things improve.
If this is done it’s important to include in the corporate minutes the record showing that the owner was underpaid at the time the agreement was entered into. The minutes also should show that the contingent payment out of future profits is merely intended to provide an incentive for the owner to put forth his best efforts to build the business and to make up for the periods of underpayment.
Attention to such details when planning compensation arrangements should help the owner fend off or blunt future attacks on compensation when the business proves highly successful and substantial compensation is paid under the agreement.
Passive Loss Carryover Utilizer for C -Corporations in New York
Passive activity losses are generated by a trade or business in which you do not participate on a regular, consistent and substantial manner during the year or by rental activities in which you do not actively participate. Because passive activity losses can only be claimed against passive activity income during a year, the losses are often not used up in that year. The amount of unused passive activity loss is carried forward to be offset against subsequent years income. To the extent losses exceed income in future years, they are suspended – doing little good, even though they are not completely lost.
The greatest tax advantage is realized from effectively utilizing these passive activity losses, rather than continuing to carry them forward. One example of a strategy that would effectively utilize passive losses is dispose of a passive activity. Another strategy is to increase the amount of gain from passive activities, perhaps by converting a currently active business into a passive one.
Personal Service Corporation
A personal service corporation is a c-corporation where the main work of the company is to perform services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, the performing arts, or consulting. A Personal Service Corporation’s stock is usually owned by employees, retired employees, or their estates.
A Personal Service Corporation is subject to special tax rules, including the ability to use the cash method of accounting and the burden of taxation at a flat rate of 35% while it remains a qualified personal service corporation. Also, if dividends are not paid regularly, and earnings are retained, it could become subject to the accumulated earnings tax. In addition, in certain circumstances, the IRS is empowered to reallocate income and deductions between the corporation and its shareholders. Other possible risks include a determination by the IRS that compensation to employee/shareholders is unreasonable, or the passive activity loss or the at-risk rules apply.
While there are risks at doing business in the form of a PSC, there also are benefits. The rules are highly technical, however, and avoiding the pitfalls that result in higher taxes requires careful tax planning. Such planning will enable you to maximize the benefits of the personal service corporation while minimizing the risks.
The rules for a C-Corporation are rather complex. Please feel free to contact MEDOWS CPA, PLLC for a consultation on how our Manhattan CPAs can help you with the accounting for your C-Corporation and how we can minimize your C Corp taxes in NYC.