The Future of Small Business C-Corps

By SBE Council at 10 April, 2019, 9:49 am

by Raymond J. Keating-

Traditional C corporations are often thought of as big businesses. In reality, the bulk of C corps are small enterprises. And the 2017 business tax reform and relief measure has made the C corp a more appealing organizational structure for more entrepreneurs.

Consider that, according to the latest data from the U.S. Census Bureau, 73.9 percent of employer C corporations have fewer than 10 employees, 84.9 percent fewer than 20 employees, 96.4 percent fewer than 100, and 99.0 percent fewer than 500 workers. If we add nonemployer corporations into the mix, then C corps with fewer than 20 workers come in at 89.5 percent of all C corporations.

Nonetheless, while the total number of U.S. businesses has grown, the number of C corporations actually has declined since the mid-1980s. The number of C corporations peaked in 1987 at more than 2.5 million, having grown rather steadily looking at data back to the late 1950s. Subsequently, though, the decline in the number of C corps has been fairly steady.

While C corps were on the decline, pass-through business entities, such as S Corps, LLCs, partnership and sole proprietorship have been on the rise. Consider that there were 2.55 million C corps in 1987, based on IRS data, and that had fallen to 1.79 million in 2015. That has a lot to do with taxes. Pass-through entities have their profits taxed only once at the individual level, while C corp returns are taxed at the business level by the corporate income tax, and then shareholders pay taxes on dividends and capital gains. Plus, the Reagan tax relief and reform measures of the 1980s dramatically reduce individual tax rates – in essence, flipping the tax advantages from C corps to pass-throughs. So, for most businesses, going the pass-through route was a no-brainer, unless one was seeking venture capital and/or planning an IPO.

But with the corporate income tax rate dropping to 21 percent under the late-2017 tax measure, the C corp path became an option for certain businesses. The Wall Street Journal just published a piece on that possible choice. It was noted that the lower corporate income tax rate combined with a limited capital gains exemption (Section 1202) from the Obama era worked for one business:

“The strategy is particularly advantageous for business founders who expect to start small, keep earnings inside the company, make annual profits and then cash out. If a taxpayer holds C corporation stock for five years and follows the technical rules, capital-gains taxes on a subsequent sale get erased—on gains up to $10 million or 10 times the original investment, whichever is greater.”

Later, it also was pointed out: “Some startups … are now choosing C corporation status, with their advisers highlighting the advantages of Section 1202. Business owners can’t be sure, of course, how long Congress will keep the 21% tax rate and that uncertainty is a consideration.”

Ironically, other tax increases being discussed could make this option more attractive:

“Future moves by Congress could make people more likely to use Section 1202, however. Democrats have been considering sharp increases in tax rates on individual income and capital gains but jumps in the corporate rate may be restrained by a desire not to create rate gaps with other countries.”

Of course, there are “buts” – indeed, many “buts.” The Journal, for example, noted:

“The Section 1202 strategy doesn’t work for everyone. Like the new pass-through break, it comes with a list of businesses that aren’t eligible, such as consulting firms and medical practices. When the stock is issued, businesses can’t have gross assets exceeding $50 million. Buyers may ultimately pay less for the company because it can’t be structured as an asset sale where the buyer gets deductions, said Gregg Polsky, a tax law professor at the University of Georgia… It also may not be right for people who need to live off their business profits, because taking money out of the corporation will trigger dividend taxes.”

This situation speaks to the need for entrepreneurs to explore assorted options when choosing a business structure. It also speaks to the benefits of tax rate reductions, the benefits that would emerge with more significant tax rate reductions, and a significant need for true tax simplification.

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Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.