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Let's say I am receiving income in a corp from multiple entities for consulting services and most of the money I make I keep in my company to potentially pay out dividends in future years.

Would it make sense to split the income (and therefore the profits) between multiple corporations to keep in the lowest corporate tax brackets?

Let's say I have a yearly profit of $120,000. If the current tax brackets for corps are as follows:

   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%

It seems I should set up 3 corporations, have my clients pay each of them about $40,000, and thus each corporation would only get taxed 15%. Thereby saving $12,000-$23,000 in taxes.

I could easily imagine creating N number of corps and spreading profits between them all to have the lowest tax rate.

This all seems pretty easy and obvious to me, yet I don't see any advice on the subject anywhere on the internet.

Is this legal?

Am I missing something fundamental? Because otherwise, it seems like a pretty huge tax loophole that I would imagine would be heavily abused.

  • 2
    On a practical note: Individuals rarely setup C corporations, and anybody willing to go through the exercise you describe would more easily avoid the U.S. corporate tax by simply paying out net profits to employees and/or shareholders, or otherwise spending the accounting profit before the end of the tax year. My guess is that corporations pay the corporate tax only when they want to retain capital and the tax is lower than the cost of raising capital. – feetwet Jul 11 '15 at 0:42
  • @feetwet, no, dividend payouts are always subject to corporate income taxes, only the salaries are tax free. – cnst Jul 25 '15 at 6:10
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    @cnst I'm not strong enough on the intricacies to be confident, but my understanding is that taxability of dividends in an S-Corp is rather more complicated than that. – daffy Jul 25 '15 at 21:14
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    @daffy, but the question must be about C corps and individual tax deferment, which is non-sequitur for S corp selection – cnst Jul 25 '15 at 21:32
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    Anything done only to reduce tax liability and with no legitimate business purpose is a sham. Shams have no effect on your tax liability, they are ignored. See, for example, Kirchman v. Commissioner or Nicole Rose Corporation v. Commissioner. – David Schwartz Jul 15 '16 at 9:09
2

Generally speaking, this is handled by the rules on "controlled groups." See Revenue Code §1563(a) for "mechanical ownership tests, which are used in determining if a controlled group situation exists."

  • 2
    This would be a better answer if you could digest the IRS's pubs on this and how they relate to the original question. E.g., is the punchline that the earnings of a "controlled corporate group" are aggregated for purposes taxation? – feetwet Jul 25 '15 at 17:25
2

I have extensive domain knowledge of your question.

In short, your plan won't work. Here's why...


Corporate Taxation and the double taxation problem

Corporations are taxed in the U.S. as separate legal entities (unless they meet certain exceptions described below). Therefore, if your corporation does not avoid being taxed as a separate legal entity, your plan will fail due to the “double taxation” problem. I.e, Your corporation will be taxed first at the corporate level. Then after you pay the corporate tax, YOU WILL BE TAXED AGAIN as an individual, when you take the money out of the corporation via income or dividends. Or if you decide to leave the money in the corporation, there is an excess retained earnings penalty.


Subchapter-S election and "flow-through" entities

The way to avoid the double taxation problem is to make a "Subchapter-S election” for your corporation. This "S-election" will cause the corporation to be treated as a “flow through” entity for taxation purposes — allowing the owners to be taxed at the individual level only. The IRS imposes additional limitations and restrictions on these "S-corporations" and their ownership structures. Limiting things like the number of owners the corporation can have etc. The problem is that even with this subchapter S election, your concept still won’t work. This is because ALL your income will "flow through” all your corporations (via IRS Form K-1) and accrue to you at the individual level. Therefore, nullifying the “compartmentalization of income” effect you were trying to achieve.


Conclusion

In short, your plan won’t work. There are too many rules in place to effectively close the loophole you imagined might be.

Disclaimer: I am not a lawyer or an accountant. This answer is not legal or accounting advice. Please consult the proper professionals for appropriate professional advice.

  • Can you provide a citation for your answer? – March Ho Jul 25 '15 at 12:11
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    The "controlled group" situation wasn't really a problem at the scale of small business flow-through S-Corps. It was a problem at the scale of C-Corps, where the cost of the more complicated structure was offset by much bigger tax savings. From the IRS publication linked in my answer: Over time some medium and large businesses began taking advantage of the lower tax rates afforded small businesses by organizing their structure into multiple corporate forms. – daffy Jul 25 '15 at 13:28
  • Mowzer, thank you for your contributions to Law.SE! Regarding your disclaimer: please weigh in on meta.law.stackexchange.com/q/178/10 -- we're trying to determine whether there is a site-wide solution that will address this. – feetwet Jul 25 '15 at 17:21
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    But this answer does not address the question at all! The questioner specifically talks about deferred income, and the tax brackets for C corporations, and what you instead suggest is going for an S corp, which CANNOT keep any income in itself year-over-year. You then go on and mis-attribute to the questioner that he wants to setup multiple S corps, which would indeed make no sense, but that's not what the question was about! There's not really any indication that the author was not aware of the double-taxation of the dividends, so, I don't think your general answer is appropriate. – cnst Jul 25 '15 at 19:12
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i am not a lawyer, I am not your lawyer

Tax laws are entirely dependent on jurisdiction, without that all answers are guesswork.

So here is the guess.

It is almost certainly illegal; as you say, if it wasn't then everyone would do it and they aren't so it is.

Typically, tax laws close this loophole by "grouping" or "anti-income splitting" provisions, or both.

  • For the US, this might be a good page to link to from your answer - irs.gov/instructions/i1120so – dsolimano Jul 11 '15 at 22:25
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    To say it is surely illegal without any direct reference to the law in question isn't really helpful. I get the sense it should be against the rules, but there are no straight forward documents that this is the case. – RobKohr Jul 12 '15 at 0:35
  • @RobKohr please note that when I wrote my answer the OP had not attached the United-States tag – Dale M Jul 12 '15 at 0:52
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I would guesstimate that this won't work in practice for the following reason you haven't seemed to have been aware of:

http://www.nolo.com/legal-encyclopedia/professional-corporations-29024.html

Professional corporations aren't as popular as they used to be. The main reason for professionals to incorporate -- favorable corporate taxation rules -- has disappeared. Before 1986, professionals who incorporated could shelter more money from taxes than sole proprietors or partners could. This has all changed. Most professional corporations are classified as "personal service corporations" by the IRS, which means that their corporate income is taxed at a flat 35%. So there's no longer any advantage to be gained by the two-tiered tax structure that allows ordinary corporations to save taxes on some retained earnings.

Basically, if you're, say, a lawyer or an engineer, and form yourself a corporation, all corporate income will be taxed at a flat 35%, not at the brackets you quote, so, the whole point is moot.


Additionally, after just a few years, the scheme you're suggesting may also subject your Retained Earnings in the corporation with the Accumulated Earnings Tax. (The idea is that corporations can only hold onto cash for legitimate business needs like business growth, not simply for tax avoidance.)

  • This answer improperly expands on a narrow case. "Professional Corporations" are special corporations for doctors, lawyers, etc. They're mostly out of favor because of the use of LLPs and LLCs. However some small or solo law offices are still PCs because you can't form a single member LLP, and the LLC form is often made unavailable to lawyers (e.g. in California). Some states have PLLCs for some professions. And if you did form a corporation, including an PC, Subchapter S election is possible. So the tax bit is misled as well. – daffy Jul 25 '15 at 13:22
  • @daffy, the S corp selection cannot shield any income from the owners year-over-year, yet the question was very much explicitly about "future years", so, S corps are pretty much a non-sequitur. Can you please provide links on how this answer is improper? It's my understanding that consulting engineers cannot have a non-professional corporation all to themselves, do you have information to the contrary? – cnst Jul 25 '15 at 19:17
  • the original question isn't specific to the kinds of businesses that must form professional corporations (if they select the corporate form). Your answer is. "Consulting services" does not suggest a licensed profession in the US context. As to S-Corps, I was implying that most PC's, so long as we're talking about them, are going to file as S-Corps. As where they are still formed it is typically because of ineligibility to form a LLP or LLC (i.e. solo lawyers). And so the corporate tax rate should not apply. It's somewhat tangential, given that PC's are a distractor here. – daffy Jul 25 '15 at 20:26
  • @daffy, but it is, it's specifically talking about consulting services, likely of professional nature, and, as already pointed elsewhere in this thread, deferred personal income taxation. So, why did this got downvoted, if it actually answers the question as proposed? Why bring up S corp selection when the questioner is clearly interested in something different? Where in my answer am I being wrong? – cnst Jul 25 '15 at 22:37
  • In your understanding of what a PC is. 'PC' is a term of art with a specific meaning. There's no 'likely' about it. Professional Corporations are creatures of statute. They're specifically for certain enumerated professions where they exist, and not available to others. Where they exist, their use is mandatory for those professions, and a general corporation may not be used. The PC is not available to most business that the tax code would consider 'consulting services.' Beyond that, and practically speaking, most businesses organized as PCs are going to be filing as S-Corps. – daffy Jul 25 '15 at 23:57

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