Did you know the federal tax code favors corporate debt over equity for closely held C corporations? Don’t miss out on tax savings! Here’s what you need to know.

C Corporation Basics

A C corporation is an independent legal entity in which its owners or shareholders are taxed separately from the corporation. Hence, the business profits are taxed twice – once as business income at the entity level and again as dividends at the shareholder level when the profits are distributed out to the owners. Additionally, C corporations cannot deduct amounts paid as dividends to its shareholders.

Tax planning for C Corporation: Avoiding double taxation is the goal

The tax advantages to debt over equity financing is determined by the rate of tax applied to the profits of the C corporation.

• C corporation rate: The federal tax rate is a flat 21%.
• Individual rates: The top federal tax rate is 37%. Long-term capital gains and qualified dividends are taxed at 20%. High earners might also pay a 3.8% tax on net investment income (capital gains, dividends and interest).

Tax savvy strategy: Include third party debt and/or some owner debt in the c corporation structure

The main advantage of using third-party debt financing (i.e. borrowing money from external lenders, such as banks or other non-bank financial institutions) for a C corporation is that shareholders do not need to use as much of their own money to obtain additional capital.

Even if the owners can afford to fund the business entirely through equity, it’s not advisable for tax reasons. The shareholders cannot withdraw all or part of their equity investment later without triggering double taxation. Doing so can be quite costly. The C corporation will pay tax on the profits of the business and the shareholder will pay tax again when the profits are distributed to them as dividends.

With third-party debt included in the corporation’s capital structure, it will be less likely that the shareholders will need to receive dividend distributions to recoup their initial investment as they will have less money tied up in the business. The corporation can pay off the debt with its cash flow from operations and still own 100% of the company with a smaller contribution of capital upfront.

Owner debt

The use of owner debt in a C corporation capital structure is another way to get around the double taxation issue.

Owner debt is personal money that the shareholder loans to the business to finance the company. The owners can withdraw this part of their investment tax-free because loan repayments are not taxed. The shareholders will also receive additional cash from the corporation in the form of interest payments. They will have to pay tax on the interest income received, but the corporation will get an offsetting deduction of the interest expense unless an interest expense limitation applies, which is unlikely for small or medium-sized businesses.

The Tax Cuts and Jobs Act of 2017 imposed a limit on interest deductions for certain businesses. For 2024, corporations with average annual gross receipts of $30 million or less over the past three tax years are exempt from the limitation.

Picture this:

You are the sole owner of your C Corporation. You are planning to use your business to purchase the assets of The ABC Corp for $6 million. You intend to finance the purchase by contributing $2 million of your own funds to the corporation’s capital and securing an additional $4 million loan for the corporation. Through this strategy, you will be able to recoup $4 million of your investment through tax-free repayments of the principal on the corporate debt. You will receive additional cash from the corporation via the loan interest payments. You’ll need to pay income tax on the interest you receive, but the corporation can deduct this interest as an expense, provided it meets the specified conditions.

In contrast, let’s say that you financed the transaction by contributing the entire $6 million of equity capital to purchase the assets of The ABC Corp. If you later wanted to withdraw all or a part of that amount, the double taxation issue would come into play. The corporation will pay tax on the profits of the business, and you will pay an additional tax on the profits when they are distributed to you as a dividend.

Questions? Wondering how you can avoid double taxation? Contact us.