My software business makes nothing for years, then a big chunk of money all in one year. Is a C-corp the best structure for tax purposes?

Question

I make video games by myself for a living.

This process involves many years of unpaid work before a game is released, and then a sudden "windfall" type wave of money when the game finally comes out. In a single year, these earnings can appear huge (like, several hundred K in a single year), but spread out over the time it takes to actually make the game, we don't make that much money per year.

Our problem is that for tax purposes, we are "rich" one year, and taxed at the highest rates, but make so little in the other years (so poor) that we can't even take advantage of the personal/child deductions in those years.

If we spread this income out over all the years, we'd be taxed at a lower rate each year and be able to take deductions every year.

My "back of the napkin" calculations are showing a hug difference in tax paid for the same income received in one year or spread equally out over four years, roughly a 70% reduction in taxes.

And it's really "not fair," because we're not rich, nor are we living richly, but we're being taxed like we are rich that one year when the money comes in, but we need that money to be able to survive through the other years while I make the next game.

The only way I can see to "spread the income out" over more than one year would be through a c-corp.

Example:

Suppose that I spend 3 years making a game with no income, and the year that I ship it, it brings in $400K. I could pay myself $100K that year, and keep the remaining $300K in the c-corp as justifiable retained earnings (to make more games), which would be taxed as profit at the corporate rate of 21%.

Over the next three years, there would be no income as I worked on the next game, but I could still pay myself $100K per year as salary, and pay personal income tax on that salary. But that $100K/year would be a loss for the c-corp, which could be carried forward and back as needed to re-coup the 21% that was paid in corporate taxes.

Then, after three years, the money would all be gone, with a net corporate income of $0 (thus, no corporate taxes paid, with the original tax refunded through carried losses), but personal income of $400K spread over four years of $100K, and personal income tax paid on the whole amount.

But then I'd ship the next game, bringing in $400K again, and the process would continue.

Earning $100K/year for four years is MUCH better in terms of taxes than $400K in one year and $0 for three years, right?

And the only way to achieve this is through a c-corp, right?

Am I missing anything here?

There's a similar post here where everyone answers that it's not possible:

Strategy to offset a big one-time windfall or gain/income for tax purposes?

But.... how do the big companies that make movies or video games do it? They might spend $100M making a movie/game over 5 years, and then suddenly get $110M in one year when the movie/game comes out. If they spend $110M on the next movie/game over 5 years and it flops, I'm SURE they're working it out so that they're not paying taxes on the $10M "profit." It was eaten by losses later. But all their employees paid tax on the entire $210M, which was paid to them as salary over the 10 year period. The company effectively made $0, though. So the dreaded "corporate tax rate" or "double taxation" is a non-issue.

And yeah, seek professional advice. But I like to do things myself, and I'm assuming that other people here like to do things themselves as well, or else we wouldn't be here...

Answer 1

C-corp

A C-corp can retain earnings (unlike an S-corp, sole proprietorship, or partnership). However, remember that you also have to pay corporate tax on the corporate income. And you have to pay additional charges for a CPA. A Certified Public Accountant is required to audit the corporation's books, usually quarterly. You can't do your books yourself anymore (unless you are a CPA and even then there might be conflict of interest laws).

My expectation would be that you will not do better the first year (you may even be a bit worse off). However, what that first year buys you is the ability to carry over losses in future years. So the first year you make, e.g. $200k. You pay corporate income tax. You pay yourself $50k plus benefits, taxes deducted. The second and third years, you take a loss from paying yourself. Then in the fourth year, you release another game and make another $200k. You can now apply the losses from the second and third years to that fourth year income.

There may be a pass through way to accomplish that. The loss is created by the salary that you pay yourself. Maybe you can make that work with one of the pass through methods (sole proprietorship, partnership, S-corp). Loan the company the money to pay your salary and then pay back the loan on release. Or something like that. That's a great question to ask an accountant.

There may be some other options to smooth out your income.

401k

If you can do a solo 401k, you could do a traditional in the year where you have high income. Then in years when you do not have income, convert part or all of the 401k to a Roth IRA. Then you have to pay income tax on the Roth conversion, but you get to use your exemptions and deductions.

This has the effect of shifting income from the high income years to the lower income years.

I'm not up on all the details of how this might work. E.g. what limitations there might be. That might make a good separate question.

Release scheduling

You describe your income as coming in just one year. Is that really necessary?

I take it that you get a lot of income in a relatively short period of time as soon as you release the game. But it's not instantaneous. You get some income the first week after release and then less income each week until it drops to a negligible amount after some period.

What if you released the game towards the end of the year? Then your initial income would come in one year and the follow-up income would come in a subsequent year. This wouldn't cover the full three years of development of the next game, but it would at least drop your $200k single year income to to two $100k years.

Now if you do the 401k option, you can contribute to the traditional for two years before converting to Roth in the third year. A $31k conversion should at least use up your deductions and exemptions in the third year.

Teams

One option would be to hire a team to develop each game. So instead of doing the whole thing yourself, you would be sharing the work with others. Then you might release a game every year.

The downside is that teams are less efficient than individuals. This loss of efficiency might cost you more than the taxes.

Pooling

Presumably you're not the only developer with this problem. Why not find one or more others and pool with them? Your basic problem is that you have income three out of seven years. If you find someone else with the same problem, you can pay the others out of your income when you have it. Then they pay you out of their income.

You'd need to make a pretty strong contractual agreement to cover eventualities, but your group could invite successful developers to join you. Perhaps you might even take software submissions. Your group does the marketing and spreads out payment. Each developer contributes software.

I believe that this is the answer to how big companies do it. While each movie or game might take three years to release, they can release two a year (each of which took three years to make). Part of your problem is that you are the only developer. A pool of ten would be more sustainable.

It's also worth noting that movies have a longer release schedule. There's the theatrical release, the DVD release, the pay channel release, and the free channel release. It may actually be difficult to fit that into one year.

Existing gaming company

You might partner with an existing gaming company, like Ninja Kiwi or Armor Games. You'd be looking for someone with reasonably steady income. Then have that company take the release income, which they then pay you over time.

This is like pooling but less complicated.

The danger here is if the company goes out of business during the relationship. You can end up with stock when you were expecting to get money. You also may have less control over the sales process.