Posted over 8 years ago

ROBS 401k Double taxation with a C Corporation Franchise Venture

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QUESTION:

I just had a question about double taxation with a C Corporation venture. I met with my franchiser yesterday and talked about my plan. He has never dealt with a franchisee using a 401k rollover as business startup to date but is very interested in finding out how the process works. We discussed the fact that I will need to setup a C Corporation, at that point he became a little concerned. He said that he usually does not recommend using a C Corp because you basically have to pay tax twice. Honestly I don't have a clue what the difference is or how the taxation works. Hopefully, you have recognized this potential situation and have a plan in place for how to deal with it . If you could explain that to me it would be gratefully appreciated. Please let me know and I will pass the information to my franchisor.

ANSWER:

I wanted to share some information that addresses how double taxation works with respect to a C-corporation that is funded with retirement funds via a rollover as business startup (Key takeaway: the double tax effect is significantly mitigated):

C-corporation vs. LLC/S-Corp:

In terms of taxes the choice between a C-Corp and an LLC/S-Corp will really depend on your particular circumstances and ultimately what you make. While some advisors will almost always recommend an LLC/S-Corp over a C-Corp there are certain advantages of a C-corporation generally - see for example, the advantage discussed in the following article: http://www.legalzoom.com/incorporation-guide/corporate-tax-advantage.html As a general matter, those advisors will recommend an LLC/S-Corp because of the perception that C-Corporations are subject to a "double tax" (where the "double tax" refers to the fact that the corporation must pay tax on its income and any corporate profits distributed to the stockholders are subject to capital gains tax). While this may be generally true, it is worth noting that with respect to our 401k business financing plan (i) any double taxation effect is mitigated by the fact that any dividends paid with respect to the stock held in your 401k will paid to your 401k on a tax-deferred basis; and (ii) any taxable income at the corporate level can be reduced by a reasonable salary paid to you as an employee of the corporation (since this would be an expense to the corporation).

Ultimately, if you want to use your retirement funds to finance the business the business must be organized as a C-corporation. As such, perhaps a better comparison would be (i) the cost to access to your retirement funds, vs. (ii) the cost to obtain other types of financing or the cost to simply withdraw the money from your retirement account and pay the applicable taxes and penalties. For example, consider the costs of our plan vs. a $100,000 loan with a 7 year term at an interest rate of 7%. With our plan, our set-up fee and annual fee over 7 years will total $7,000 plus an additional estimated costs of $4000 for annual valuations and if needed premiums for a fidelity bond (estimated total: $11,000). With the loan, you would pay over $26,000 in interest (see calculator at https://smallbusiness.yahoo.com/advisor/business-tools/loan-calculator). If you simply withdraw the money from your retirement account you will have to pay a 10% penalty as well as income taxes on the withdrawn amount.

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