Choosing a Business Form 251compensate for the lower rates in the lower brackets. Certain “professional
service corporations” have only a f lat 35% rate at all levels of income. Also,
losses currently generated by a corporation may be carried back as many as 2
years to generate a tax refund or carried forward as many as 20 years to shel-
ter future income.
Although corporate rates may be attractive at lower levels of income, the
common fear of using the corporate form is the potential for double taxation.
Simply put, the corporation pays tax upon its profits and then distributes the
remaining profit to its stockholders as nondeductible dividends. The stockhold-
ers then pay tax on the receipt of the dividends, thus amounting to two taxes on
the same money. In 2001, for a corporation in the 34% bracket with stockhold-
ers in the 27.5% bracket, the net effect is a combined tax rate of 52.15%. Yet
double taxation is rarely a concern for the small business. Such businesses
generally manage compensation to their employees, who are usually their
shareholders, in such a way that there is rarely much, if any, corporate profit
remaining at the end of the year. Since compensation (as opposed to dividends)
is deductible, the only level of taxation incurred by such businesses is at the
stockholder level. Other opportunities for legitimate deductible payments to
stockholders that have the effect of eliminating corporate profit include rental
payments on assets leased by a stockholder to the corporation and interest on
that portion of a stockholder ’s investment made in the form of debt.
Thus, the existence of the separate corporate entity with its own set of
tax rates presents more of an opportunity for tax planning than a threat of dou-
ble taxation. If the corporation intends to distribute all of its excess cash to its
owners, it should manage compensation and other payments so as to show little
profit and incur taxation only on the stockholder level. If the corporation in-
tends to retain some of its earnings in the form of capital acquisitions (thus re-
sulting in an unavoidable profit for tax purposes), it can take advantage of the
lower corporate rates without subjecting its stockholders to taxation at their
level. Contrast this to a partnership where the partners would be required to
pay tax at their highest marginal rates on profits that they never received.
There are limits to the usefulness of these strategies. To begin with, one
cannot pay salar ies and bonuses to nonemployee stockholders who are not per-
forming services for the corporation. Dividends may be the only way to give
such shareholders a return on their investment. In addition, the Internal Rev-
enue Service will not allow deductions for what it considers to be unreasonable
compensation (as measured by compensation paid to comparable employees in
the same industry). Thus, a highly profitable corporation might find some of its
excessive salaries to employee-stockholders recharacterized as nondeductible
dividends. Lastly, even profits retained at the corporate level will eventually
be indirectly taxed at the stockholder level as increased capital gain when the
stockholders sell their shares.
For most startup businesses, however, this corporate tax planning strategy
will be useful, at least in the short term. In addition, entrepreneurs will find
certain employee benefits are better offered in the corporate form because