Tax Cuts and Jobs Act for 2018 introduced a new federal flat tax rate of only 21% on the C-Corp level. This may be appealing to certain traders as the previous federal corporate tax rate was as high as 39%! There is certainly a reason to be excited when income tax rates drop at such a significant rate, however, before you quickly move to set up your C-Corp you need to find out about the entire tax system.
You must explore three sets of taxes to determine if the C-Corp is still an effective choice for you:
- The capital gain on qualified dividends
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).Considering this, having a C-Corporation for a trading entity can get very costly. The double taxation on the federal level can easily wipe out the savings when the individual owning the C-Corp will have to pay 15% or 20% capital gains tax on qualified dividends (holding C-Corp stock for 60 days). Double taxation on the state level can lead to a C-Corp owner paying higher taxes than with a pass-through entity (S-Corp or LLC). There are also the potential 20% accumulated earnings taxes and personal holding company tax penalties. Thus, it’s recommended that before you jump into forming a C-Corp to consult a trader tax expert.
- Corporate state tax (applicable in 44 states)
Corporate tax rates range from 4% in North Carolina to 12% in Iowa. Nevada, Ohio, Texas, and Washington forego corporate income taxes but instead impose gross receipts taxes on businesses. South Dakota and Wyoming levy neither corporate income nor gross receipts taxes.A C-Corp could be 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 avoid IRS 20% accumulated earnings tax. 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, therefore most traders won’t trigger the Texas franchise tax.So, if you are a high income trader you may want to consider establishing residency in the state of Texas as it could save you substantial amounts in state income taxes. Simply forming a corporation in Texas may not work out as 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 entity from your resident state does.
- The accumulated earnings tax assessed on excess retained earnings
If the C-Corp does not pay dividends from earnings and profits (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.Arguing the C-Corp needs more trading capital for growing profits is likely not an acceptable reason for avoiding dividends. As said earlier, a C-Corp might be suitable for a high-income trader, but they would probably exceed the AET threshold in the first year.In addition, C-Corps have other disadvantages like no lower 60/40 capital gains tax rates on Section 1256 contracts (Futures), and that losses do not passthrough to owner’s individual tax return that may further complicate your tax filings.
Let’s explore an example when a C-Corp can deliver substantial savings:
Joe is a trader, TX resident, earns $500,000 from trading, elected MTM accounting, issues a salary of $145,000 and contributes $55,000 to a 401K plan. If Joe uses an S-Corp for his trading entity the net tax rate for all federal taxes would be estimated at $207,000. If Joe elects to use a C-Corp, his total federal tax is estimated at $128,000. The C-Corp structure delivers 2018 federal tax savings of about $79,000 vs. the S-Corp. There is no corporate or individual income tax in Texas and he did not exceed the franchise tax threshold, so the savings with the C-Corp can be significant. If joe wants to move to a state like CA, then this C-Corp structure will not work as the state will impose a 8.84% tax on corporate earnings and then 10.3% on Individual earnings whether via a salary or a dividend.
I suggest traders consult with OTA Tax Pros to discuss their 2018 projections and see which entity fits best: a partnership, S-Corp, C-Corp, or some combination thereof.