To strengthen the fundamentals of a company and build wealth, I was taught decades ago in business school to pay only secondary attention to tax laws. In other words, do not get distracted by trying to make the tail wag the dog. Tax incentives and special deductions come and go, so it’s generally not a good idea to structure a company primarily to gain ephemeral tax sugar highs.
The American Taxpayer Relief Act of 2012 with its new Section 1202 provisions to exempt capital gains taxes on qualified C corporation business investments made in 2013 has turned my head this year. This new law may be an exception to the rule where a traditional corporate structure, a C corporation, may indeed have significant benefits for small business owners and investors under certain circumstances.
I advise small business owners to form their companies as pass-through entities such as limited liability companies and S corporations where there is no corporate tax or personal liability. Typically, the reason to form a taxable C corporation is to be prepared for a public offering, which is not in most small business owner’s minds. However, creating wealth in a business that is to be harvested tax-free as part of an investor or owner exit strategy is of high interest to small business owners.
Many of my small business clients have revenue under $5 million annually. These types of companies often have the opportunity to double their sales volume over the next five years if only they had proper guidance and the financial resources for an expansion. It is hard to save up to self-finance these expansions when clients owning LLC or S corporations are taxed nearly 40 percent on their profits.
A client with a C corporation, on the other hand, could avoid this tax situation altogether by reinvesting profit back in the business. However, eventually when the company is sold or dividends paid to the owners, there will be taxes owed of up to 20 percent on the capital gains.