The C Corporation (C corp) is one of the oldest forms of business organization, and while it offers asset protection, it is widely unpopular among small business owners due to its default tax structure, which subjects income to double taxation.
The Double Taxation Problem
The primary reason small business owners generally avoid C corporations is the phenomenon of double taxation. This means that the business's profits are taxed at two different levels before they reach the owner:
- Corporate Level: The C corp pays federal corporate income tax on its annual profits.
- Shareholder Level: When the corporation decides to distribute the remaining profits to its owners (shareholders) in the form of dividends, those dividends are then taxed again as personal income to the shareholder.
This dual taxation significantly reduces the final financial return to the owners, making it inefficient compared to pass-through entities like partnerships or S corps.
The Historic Workaround for C Corps
Before the popularization of pass-through entities, business owners who wanted the corporate protection of assets, but needed to avoid double taxation, developed a common workaround. The strategy was for business owners to zero out the corporate income by paying out virtually all of the profit as a salary to themselves.
Since salaries are a deductible business expense for the corporation, this reduced the C corp's taxable income to near zero. While the owner still paid individual income tax on the salary, they avoided the second layer of tax that would have been applied if the money had been paid out as a non-deductible dividend.
The Shift to LLCs
In the past, traditional corporations and limited partnerships were the primary options for asset protection. Today, however, the LLC has become the standard vehicle for small businesses because it offers the same asset protection without the default double taxation. By creating an LLC and then, if desired, electing S corp status, owners can achieve both liability protection and a far more favorable tax structure.
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