Question

Irene operates an ice cream store called Ice Queen Irene’s Ice Cream Dream, Incorporated. Irene is the sole owner and shareholder. The company has been in operation for a few years now, so much that Irene has been able to hire employees and pay herself a salary of $150, 000 per year for being the President, CEO and Operations Manager of the company. From sourcing more affordable products, to keeping up to date with the industries latest gadgets for efficiency, Irene is a stickler for the bottom line and is always looking for ways to save money while not sacrificing the quality of her ice cream.

When Irene started her business, she didn’t seek the advice of an attorney nor CPA. Instead, she went to Instantbusinesslawyer.com to handle all of her business formation paperwork. She did not understand the differences between the various entity types, but decided on created a C Corporation because she thought it sounded the most official.

In her efforts to streamline costs, she has been going through the books of her business. One thing she noticed is that it appears she is being taxed two times on the money the company makes. When she called the IRS to give them a piece of her mind for this mistake, the IRS informed her that there was no mistake and told her to speak with a tax professional.

Irene comes into your office seeking help in coming up with creative ways to evade taxes. She tells you one idea of hers to evade taxes is to encourage cash payments from customers because, she says, “Then I can just pocket that money like it never happened and the IRS wouldn’t be the wiser!” Also, because business is going well, she plans to give herself a raise and bring her total salary up to $400,000. She read an article online that said this is a good way to get rid of that mysterious double tax. She’s also still very confused as to why the “IRS is double dipping its greedy hands into her wallet and taxing her twice,” and wants that to stop.

Identify any tax issues that arise through Irene’s situation. Also identify any relevant section of the Code, case law, or tax court memorandums that will help you resolve these issues.

Answer 1

As per given case, Irene founded an ice cream store called Ice Queen Irene’s Ice Cream Dream. The company has been in operation for a few years now, so much that Irene has been able to hire employees and pay herself a salary of $150, 000 per year for being the President, CEO and Operations Manager of the company. When Irene started her business, she didn’t seek the advice of an attorney and registered as C Corporation with help of online Portal. She noticed is that it appears she is being taxed two times on the money the company makes. When she called the IRS to give them a piece of her mind for this mistake, the IRS informed her that there was no mistake and told her to speak with a tax professional. Later to avoid tax she encouraged more cash transaction. She plans to give herself a raise and bring her total salary up to $400,000.

Before we explain lets understand C Corporation

A C corporation is a corporation that is taxed separately from its owners under Subchapter C of Chapter 1 of the Internal Revenue Code. The term is used to distinguish a C corporation from an S corporation, which is not taxed separately its owners.

   Corporate income has been subject to a federal tax (currently at a top rate of 35 percent). This income is generally taxed a second time when it is distributed as dividends that are liable to the individual income tax.

Suppose a corporation earns $1 million in profits this year and pays $350,000 in federal taxes. If the corporation distributes the remaining $650,000 to its shareholders, the distribution would be taxable to shareholders. Dividends are taxed at a top rate of 23.8 percent. As a result, only $495,300 would be left (assuming the dividends went to high-income individuals), and the combined tax rate on the income would be greater than 50 percent.

We consider this double-taxation inequitable. It discourages businesses from organizing as C corporations (which are subject to the corporate tax), encouraging them to be S corporations, partnerships, or sole proprietorships. Profits of an S corporation, partnership, or sole proprietorship are taxed only once, because the income is automatically passed through to the owners. By no coincidence, in recent years an increasing portion of businesses have been organized as pass-through entities.

The recently enacted 2017 Tax Act (originally called the Tax Cuts and Jobs Act – “Tax Reform”) made major changes to the US tax system. Because C corporations (“C corps”) are now taxed at a flat 21% federal income tax rate, many business owners are asking whether they should structure their businesses as C corps code 301 to 318.

In some instances, corporations can reduce the double-taxation of their income. For example, a corporation may issue debt instead of stock to finance an investment and deduct the interest payments in the calculation of taxable income. Alternatively, a corporation can retain its earnings and not pay dividends. The corporation would still pay tax on its earnings, but the shareholders would defer the second round of taxation until the corporation distributed the earnings or the shareholders sold their stock at a price that reflected the value of the retained earnings.

Second solution may be like there are many ways for corporations to avoid double taxation. For many smaller corporations, all of the major shareholders are also employees of the firm. These corporations are able to avoid double taxation by distributing earnings to employees as wages and fringe benefits. Although the individual employees must pay taxes on their income, the corporation is able to deduct the wages and benefits paid to employees as a business expense, and thus are not required to pay corporate taxes on that amount. For many small businesses, distributions to employee/owners account for all of the corporation's income, and there is nothing left over that is subject to corporate taxes. In cases where income is left in the business, it is usually retained in order to finance future growth. Although this amount is subject to corporate taxes, these tax rates are usually lower than those paid by individuals.

To convert to a subchapter S corporation, shareholders of a C corporation must elect to be taxed under Subchapter S of the Internal Revenue Code. The election is made by filing Form 2553, Election by a Small Business Corporation. If the corporation has already operated as a C corporation, the tax consequences of converting to subchapter S status must be considered.