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Incorporating as a C Corp: Is the Tax Savings from Qualified Small Business Stock (QSBS) Worth It?

When purchasing a business, particularly in industries like manufacturing, many business owners explore the tax advantages of incorporating as a C Corporation to qualify for the Section 1202 Small Business Stock (QSBS) exclusion. Under this provision, shareholders of qualified small business stock can exclude up to 100% of their capital gains upon the sale of the stock if certain criteria are met, making this option highly attractive for long-term business owners.


However, the key question becomes: Does the tax savings from the QSBS exclusion at the time of sale outweigh the higher tax burden of operating as a C Corporation during the holding period?


Let’s break this down using a practical example and analyze the tax implications of choosing a C Corporation structure versus an S Corporation structure.


 

What Qualifies as a Small Business Under Section 1202?

To qualify for the QSBS exclusion, certain criteria must be met:


Conditions of tax exemption under section 1202

In industries like manufacturing, which are typically capital-intensive and operationally active, many companies meet these requirements, making them prime candidates for QSBS benefits.

 

Scenario: Purchasing a Manufacturing Business

Let’s assume you purchase a manufacturing company in Cleveland, OH for $3 million and project annual profits of $500,000. You want to know whether structuring the business as a C Corporation to take advantage of QSBS will provide enough tax savings to offset the taxes you’ll pay along the way, compared to an S Corporation.


You’ve decided to pay yourself a W-2 salary of $200,000 and distribute the remaining $300,000 of annual profit as dividends (in the case of a C Corp) or pass-through income (in the case of an S Corp).


 

C Corporation Taxes (Double Taxation)

In a C Corporation, profits are subject to double taxation—once at the corporate level and again when distributed as dividends:


  1. Corporate tax rate: 21% on the $500,000 annual profit:

    500,000×0.21=105,000

    After corporate taxes, $395,000 is left for distribution.

  2. Dividend tax: When the remaining $395,000 is distributed as dividends, you pay the following taxes:

    • Qualified dividend tax (15%): 395,000×0.15=59,250

    • Net Investment Income Tax (3.8%): 395,000×0.038=15,010

    Total dividend taxes: $59,250 + $15,010 = $74,260


Total tax liability for the C Corporation:

  • Corporate tax: $105,000

  • Dividend tax: $74,260

  • Total tax liability: $179,260


 

S Corporation Taxes (Pass-Through Entity)

In an S Corporation, the profits are taxed only once at the personal income level. Here's how the taxes break down:


  1. W-2 Salary (same as C Corp):

    • Payroll taxes (FICA): $15,300

    • Federal income tax: $37,980

    • Ohio state tax: $7,980

    • Cleveland local tax: $5,820

    Total salary-related taxes: $67,080

  2. Pass-through profits: The remaining $300,000 is subject to personal income taxes at the owner’s federal and state rates:

    • Federal income tax (24%): 300,000×0.24=72,000

    • Ohio state income tax (3.99%): 300,000×0.0399=11,970

    • Cleveland local income tax (2.5%): 300,000×0.025=7,500

    Total pass-through taxes:

    • Federal: $72,000

    • Ohio: $11,970

    • Local: $7,500

    • Total pass-through tax: $91,470

Total tax liability for S Corporation:

  • Total salary-related taxes: $67,080

  • Total pass-through taxes: $91,470

  • Total tax liability: $158,550


 

Comparison of Tax Liabilities

  • C Corporation tax liability: $179,260

  • S Corporation tax liability: $158,550


In this example, the S Corporation results in $20,710 less in total taxes per year compared to the C Corporation, due to the double taxation on dividends in the C Corp.


 

Breakeven Sale Price for C Corporation

While the C Corporation has a higher annual tax burden, the QSBS exclusion can offset these higher taxes upon the sale of the business. To offset the additional taxes paid as a C Corporation, the breakeven sale price would need to be at least $3.44 million. This means you would need to create at least $440 thousand of value for the tax savings from the QSBS exclusion to offset the additional taxes paid during the holding period as a C Corporation.


 

Conclusion: Is the Qualified Small Business Stock (QSBS) Benefit Worth It?

In this scenario, the C Corporation has a higher annual tax burden compared to the S Corp, but the QSBS exclusion can provide significant tax savings upon the sale of the business. If you expect the business to appreciate and eventually sell for more than $3.44 million, the C Corporation structure can offer substantial long-term benefits despite the higher taxes paid along the way.


However, if you plan to regularly distribute profits or anticipate a more modest sale price, the S Corporation structure may be more tax-efficient due to the lack of double taxation.

As always, the decision depends on your business goals, income needs, and expected growth. Consult with a tax professional to determine the best structure for your unique situation.

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