Some FAQs About the BORSA™: Why a C Corp?, and the Myth of "Double Taxation"

Some of the most frequently asked questions we get from clients are: 

• “Why do I have to establish a C Corporation to implement the BORSA™?” 

• Why can’t I establish an S Corporation, LLC (limited liability company), LP (limited partnership), or GP (general partnership) to implement the BORSA™?” 

• Won’t I pay double tax with a C Corporation? 

The reason clients ask these questions is because they hope to minimize paperwork (tax filings) and enjoy the perceived “flow-through” or “pass-through” tax benefits of those other entities. As you will see below, that is not always the case. 

Here’s why any entity other than a C Corporation won’t work for the BORSA™. 

Consider the essence of the BORSA™ structure: a C Corporation adopts a 401(k) plan and the 401(k) participant chooses to self-direct his account to buy stock in the C Corporation.  Thus, a 401(k) plan (for the benefit of its participant) becomes a shareholder of the C Corporation.   Now consider this: 

In order to function as a flow-through entity, an S Corporation must be owned by an individual(s) or by a qualified Subchapter S Trust.  A 401(k) plan cannot be a shareholder in an S Corporation.  http://www.irs.gov/pub/irs-pdf/i2553.pdf 

LLC’s, LP’s, and GP’s are all capital-account based entities – there are no shareholders, and there is no stock to issue to the BORSA™’s 401(k) plan.  Under section 408(e) of ERISA, the only “qualifying employer securities” that can be owned by a qualified plan like a 401(k) are: 

• Stock
• Marketable obligations
• Interest in publicly traded partnerships 

Membership interests in an LLC and partnership interests in a non- publicly traded LP or GP do not meet the definitions of “qualifying employer securities”. 

Regarding the paperwork concern: 

• C Corporations file tax Form 1120 annually with the IRS.
• S Corporations file tax Form 1120S annually with the IRS.
• LLC’s, LP’s, and GP’s all file tax Form 1065 annually with the IRS. 

Although S Corp’s, LLC’s, LP’s, and GP’s do not pay income tax at the entity level – rather, they “pass through” their income gains or losses to their individual shareholders, members, or partners – they still have to file annual tax returns that delineate the “pass- through” amounts.  There is no escape from the IRS’ paperwork requirements regardless of the entity selected. 

Lastly, the concern over “double taxation” in a C Corporation: 

You often hear the statement that C Corporation earnings are subject to “double taxation”.  This may or may not be true if you own the C Corporation’s stock individually, depending on your circumstances and proper tax planning.  It is definitely not true when the corporation is predominately owned by a tax exempt retirement plan like the BORSA™ plan. 

The concerns about “double taxation” of profits stems from a C Corporation earning profits which are taxed at the corporate level,

  

Corporate Income Tax Rates: 2008

       Taxable income over     Not over      Tax rate

          $         0        $    50,000        15%

               50,000             75,000        25%

               75,000            100,000        34%

              100,000            335,000        39%

              335,000         10,000,000        34%

           10,000,000         15,000,000        35%

           15,000,000         18,333,333        38%

           18,333,333         ..........        35%

 

and then declaring a dividend to a taxable owner (i.e. an individual) of the after-tax profits, which are then taxed at the individual’s dividend tax rate (15% if your income tax bracket is >15%). 

However, a retirement plan (the 401(k) in the BORSA™) never pays tax on its earnings, be they dividends, interest, or capital gains.  Accordingly, a BORSA™ plan will never pay a “double tax” on corporate earnings.  The individual participants will be taxed on retirement plan distributions when they receive them - but that may be 10 to 20 years, or more, in the future.  If the value of your C Corporation’s stock in the 401(k) plan grows by 6% or more for 5 years, you will usually have more than offset the tax that will be due when retirement plan distributions are finally received – that is the power of tax-deferred compounding. 

Another issue that is often forgotten is the additional tax cost of accumulating profits in a flow- through entity. In a flow-through entity, the profits will be taxed to the owner at their highest personal income tax bracket.  The owner’s personal income tax bracket could be 30% or higher depending on their salary and other income.  In their early years, most small businesses have to retain profits to service debt as well as finance growth.   With a C Corporation you can accumulate $50,000 per year at the 15% corporate tax bracket rather than at the owner’s likely higher personal tax rate. 

Moreover, the biggest expense of any entity is probably going to be your salary.  The income you receive as a salary will be taxed at your same personal income tax rate, no matter what kind of entity pays it to you.  

As CPA’s we work with our clients to legally minimize the tax implications of owning, operating, and selling a business.  We have developed a number of strategies to assist our clients in funding, operating, and selling their businesses.  Please let us know if you would like more information about these services.