Now that tax reform through the Tax Cuts and Jobs Act of 2017 is no longer breaking news, it’s time we take a closer look at a question that arose for McDonald’s franchisees as a result of the change in the tax law.
One of the headline reforms of the new legislation was the slashing of the corporate tax rate from the graduated maximum of 35% to a flat 21%. This begged the question, “Is it now more beneficial for a McDonald’s Owner/Operator to be a C Corporation than a pass-through S Corporation?”
Without examining the merits of the latter choice of entity type, let us instead lay out some (but not all) of the pros and cons of operating your McDonald’s business as a C Corporation.
First, a general description of our subject entity: A C-corporation is the standard, most common type of corporation. Shareholders who have purchased stock in a company own the corporation, and these shareholders enjoy limited liability protection.
This simply means that shareholders of corporations are not personally liable for the business’s debts or obligations. Most people would consider that point a definite pro.
Perpetual existence: A C corporation will exist indefinitely, even if a shareholder or owner leaves, becomes disabled, dies, or sells off their shares. This is not always the case with many of forms of legal business entities.
Fringe benefits: C-corporations can deduct the cost of fringe benefits provided to employees such as disability and health insurance. Shareholders of a C-corporation don’t pay taxes on their fringe benefits, as long as 70% of the corporation receives those same fringe benefits.
No shareholder limit: C-corporations are able to have as many shareholders as desired. Additionally C-corporations are not precluded from having foreign (non-resident alien) shareholders (unlike S Corporations).
While these pros may seem pretty enticing, let’s now shift our attention to some of the cons of C Corporations for McDonald’s Owner/Operators.
Double taxation: Owners of the corporation pay a double tax on earnings, first at the entity level and then again when profits are distributed out in the form of dividends to shareholders. Dividends are usually taxed at the qualified dividend rate of 20%, though there is usually no preferential tax rate at the state and local level. These dividends may also be subject to the 3.8% net investment income tax, an important (and costly) detail that it often overlooked.
No personal income off-set: Another tax-related downside is that since the C Corporation pays taxes at the entity level and passes no income through to shareholders, those owners are not able to use C Corporation losses in any given year to offset personal income from other sources.
Even more taxes: If the C corp accumulates cash, it can be subject to one of two penalty tax regimes: the accumulated earnings tax and personal holding company tax.
A C corporation is subject to the accumulated earnings tax if it accumulates earnings beyond the reasonable needs of the business. A gray area to be sure, but one to pay close attention to as any extra taxes are bad taxes.
Additionally, closely held C corporations are subject to the personal holding company tax of 60% or more of their income is passive in nature, and which is retained in the C Corporation and not distributed to shareholders.
The Tax Cuts and Jobs Act was sweeping tax reform that reached almost every corner of the internal revenue code. While a 14% cut in the corporate tax rate may seem like a deal too good to pass up, C Corporation shareholders still can’t escape the dreaded double taxation.
It is important to consult a trusted tax advisor who can review your specific facts and circumstances and help you decide it a C Corporation is the best fit. We’ve performed such analysis for many McDonald’s franchisees – contact us for more information.