The Tax Cuts and Jobs Act (TCJA) introduced a major change for businesses: a flat 21% federal corporate tax rate. That change made the C corporation structure far more appealing for many business owners.

But before you jump in, it’s important to understand both the advantages and the potential tax pitfalls. While a C corporation can offer some compelling benefits, there are also traps you’ll want to avoid especially when it comes to double taxation and IRS scrutiny.

Let’s break it down.

The Appeal of the 21% Corporate Tax Rate

Prior to the TCJA, C corporations were taxed on a graduated scale, often resulting in significantly higher effective rates. The switch to a flat 21% rate means many businesses can now operate as a C corporation and pay less federal income tax on paper.

But that’s just one part of the equation.

The Double Taxation Problem

Here’s the classic downside to a C corporation: corporate earnings can be taxed twice.

1. Your corporation earns income and pays the 21% corporate tax. 
2. When you distribute profits as dividends to shareholders (like yourself), you pay another layer of tax on those dividends,  potentially up to 23.8% at the individual level (including the Net Investment Income Tax). 

So while the initial tax bill may look low, the real effective tax rate can climb quickly once profits leave the corporation.

Can You Avoid Double Taxation by Keeping the Money Inside the Business?

In theory, yes but there’s a catch. If your C corporation retains too much income without a clear business need, the IRS may step in and assess the accumulated earnings tax.

Here’s how it works:

• This extra tax kicks in when retained earnings exceed $250,000 (or $150,000 for a personal service corporation). 
• If you can’t show a legitimate economic reason for holding onto the profits like funding expansion, hiring, or capital purchases, the IRS can levy an additional 20% tax on the excess earnings.
  

The “Zero-Out” Strategy Isn’t Foolproof Either

Some business owners try to avoid the dividend issue by paying themselves large salaries or bonuses, which are tax-deductible for the corporation and taxed only once at the individual level.

It sounds like a solid workaround but it can backfire.

The IRS requires that compensation to shareholder-employees be reasonable. If it’s not, they can reclassify the excess as disguised dividends and apply double taxation anyway.

A Real-Life Example:

In 2016, the Tax Court sided with the IRS in a case involving a law corporation that eliminated its corporate income through year-end bonuses to its shareholders. The court found that the bonuses were not reasonable, and were really just masked dividends, subject to double taxation and penalties.

So… Should You Become a C Corporation?

That depends. The flat 21% rate can offer real savings in certain situations—especially if:

• You don’t need to take large distributions each year
  
• You plan to reinvest most profits back into the company
• You want to build a long-term asset with a clear exit strategy 

But the risks of double taxation, IRS scrutiny, and future tax law changes mean a C corporation is not a one-size-fits-all solution.

At BASC Expertise, we help business owners navigate these choices with clarity. If you’re thinking about switching to a C corporation or just want to see how your current setup compares, we can do a side-by-side after-tax analysis to help you make an informed decision.

Give us a call to schedule your entity review. We’ll walk you through how the numbers work and help you avoid costly surprises.