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While the choice of a business form, whether LLC or corporation, should seldom be driven by tax considerations, understanding how different entities are taxed is important to making the best choice for your business. In addition to protecting your personal assets from business creditors and providing your company with enhanced access to financing and credit, operating as a corporation provides access to tax strategies that aren’t otherwise available.
Although a corporation is a corporation is a corporation for state business law purposes, there are two distinct types of corporations for tax law purposes. One type is often referred to as a “regular corporation” or a “C corporation” because it is governed by subchapter C of the Internal Revenue Code. This type of corporation is a taxpayer in its own right. It must file its own tax return and pay corporate-level taxes on its income.
The other type of corporation is known as an “S corporation” because it is governed by subchapter S of the Internal Revenue Code. (You will sometimes see mention of it under the older name, “small business corporation,” although this term has fallen from favor as the number of permitted shareholders has increased.) Unlike the C corporation, the S corporation is not a separate taxpaying entity—its income, losses and other tax attributes are passed-through to its shareholders in proportion to their ownership percentages.
This article focuses on the tax advantages—and disadvantages—of operating as a C corporation. For information on S corporation taxation and how to elect to be taxed as an S corporation, see our articles “S Corporation Tax Benefits” and “How to Make an S Corporation Election."
When discussing C corporation tax, one of the first topics that surfaces is the fear of “double taxation.” Often the concept is poorly understood, which contributes to the concern. First, generally only dividend payments are “double taxed.” Plus, there are many strategies to reduce the risk of income being taxed twice and recent law changes have weakened the impact even further.
First, let’s define when “double taxation” comes into play. Because a regular corporation is a separate taxpayer, it will file its own tax return and pay taxes at the corporate tax rates on its income. This means that any income that is paid as dividends will be taxed twice—once on the corporation’s return and again on the shareholder’s return. However, note that only income paid as dividends is actually taxed twice. Income distributed as salary or deferred compensation is a deduction for the corporation. This means that the amount of compensation paid is deducted from the amount of corporate income that is subject to taxation.
A is a separate entity for both state law and tax purposes. A C corporation reports its income and claims its deductions and credits on Form 1120. Once all the corporation’s deductions and credits have been claimed, the remaining income is normally taxed at the using the corporate income tax rates shown in the table below. Unlike individual tax rates, the corporate tax rate is not adjusted every year to account for inflation.
CT Tip: There is an exception for personal service corporations, which are corporations whose employees spend at least 95 percent of their time in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. These corporations are taxed at a flat rate of 35 percent of net profits.
However, good tax planning can often minimize the impact of double taxation, while leveraging the corporate structure to provide other benefits. Plus, with the top individual rate now higher than the top corporate rate and with the ability of a C corporation to retain earnings rather than passing the entire amount through to the shareholders, a regular corporation may be the best tax-advantaged choice in some cases.
Salaries Paid Reduce Corporate Taxable Income
As noted earlier, not all corporate income is at risk for double taxation. Employees—including owner-employees—of a corporation are entitled to be paid “reasonable” salaries. These salaries, as well as benefit payments and deferred compensation payments, are deducted from the corporation's profits before tax due is calculated. As a result, the salaries are not taxed at the corporate level for federal income tax purposes. In some cases, the entire net profit may be offset by salaries to the owners, so that no corporate income tax is due. (Of course, the recipients will have to pay income tax, and both recipients and the business will have to pay employment taxes on the salary payments).
Corporations Can Accumulate Earnings for Reasonable Purposes
One major difference between C corporations and pass-through entities is that the owners of a C corporation are only taxed on income that they actually receive from the corporation. Because a corporation is a taxable entity that is separate from its stockholders, its excess profits (profits remaining after being taxed at the corporate level) are not, as in the case of unincorporated businesses and S corporations, taxed to the owners when they are earned. The profits are taxed only if and when they are actually distributed to the stockholders as dividends. This means there is no taxation on retained earnings.
Example: ABC, LLC has $300,000 of profits for the year. ABC plans to expand its operations during the next year. It pays each of its three owners $50,000 each and keeps the remaining $150,000 in the company bank account. Each owner must report and pay tax on $100,000 worth of income from the LLC—even though each one only received $50,000—because an LLC is a pass-through entity.
XYZ, Inc. (a regular corporation) also has $300,000 of profits for the year. Like ABC, LLC, XYZ is planning to expand its operations during the next year. It pays each owner a salary of $50,000 and retains the rest in the corporation’s back account. Each shareholder pays tax only on the salary received.
There is a special tax—the accumulated earnings tax—that exists to prevent corporations from retaining unlimited amounts of income. The law provides that most corporations can accumulate up to $250,000 in retained earnings without triggering IRS scrutiny. In addition, the accumulated earning tax will not apply as long as the accumulation is related to a reasonable business need. If a business that plans major capital investments or expansions, the ability to accumulate income within the corporation can actually save taxes in the long run.
CT Tip: Good documentation of the business need is essential. This includes having the appropriate company resolutions adopted by the directors and recorded in the company’s record book. Having a business plan that documents planned expansion is also valuable.
Only Dividend Payments Are Taxed Twice
If the corporation pays dividends to the shareholders, those payments are subject to corporate-level income tax. However, the individual does not have to pay self-employment tax on the dividends—which can actually result in a lower overall tax bill than would occur with a pass-through entity, such as an LLC or S corporation.
Although the individual shareholder must pay tax on the dividend income, qualifying dividends (and most United States corporate dividends fit into this definition) are taxed at capital gains rates; not at the individual's top marginal tax rate. Finally, dividends paid to a shareholder that actively participates in the business are not subject to either of the new Medicare taxes: the 0.9 percent tax on earnings or the 3.8 percent tax on net investment income.
CT Tip: If your corporation is profitable but does not pay any dividends for an extended period of time, the IRS is likely to conclude that some of the salaries paid to owners are really disguised dividends. The IRS can disallow some or all of the salary deductions, resulting in a large tax bill plus interest and penalties. So, the safest course of action is to make sure all salaries are not significantly higher than industry standards, and to pay out some dividends each year.
In addition, proper corporate documentation is critical if the payments are challenged by the IRS. Make sure the corporate record book contains resolutions that authorize all salaries and dividends
Corporations Need to Watch Out for AMT
Like individuals, corporations can become subject to an Alternative Minimum Tax (AMT) if they have gained the benefit of "too many" tax preference items. For corporations that are subject to AMT, the general rate is 20 percent (the rate is reduced to 15 percent for certain specific items.) However, many small corporations can avoid corporate AMT--oftentimes far more easily than high-net-worth individuals can.
Although a corporation is a taxpayer in its own right and dividends paid are subject to double taxation, there are ways to reduce that impact, such as paying salaries and retaining earnings. Plus, operating as a corporation provides other, longer-term tax planning advantages. Corporations can be recapitalized or restructured more readily than an LLC and transfers of ownership can be accomplished in a wide variety of ways. A tax professional can help you decide if the corporate structure is the best fit for your business and your long-term goals.
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