C Corporation Taxation

In General: The label "C-corporation" refers to a regular, state-formed corporation. To form a corporation, you must file Articles of Incorporation and pay the requisite state fees and prepaid taxes with the appropriate state agency (usually the Secretary of State).

Separate Legal and Tax Life: A corporation, properly formed and operated, assumes a separate legal and tax life distinct from its shareholders. Alternately, note that a corporation improperly formed or operated runs the risk of losing its separate legal and tax life, effectively exposing you and other owners/shareholders to the liabilities of the business. A corporation pays its own taxes at corporate income tax rates and files its own corporate tax forms each year (IRS Form 1120). A C- corporation has the option to use a fiscal year end (other than December 31st ), while an S-corporation typically must use December 31st.

Management and Control in Corporations: Normally, a corporation's management and control are vested in the board of directors who are elected by its shareholders. Directors generally make policy and major decisions regarding the corporation, but do not individually represent the corporation when dealing with third persons. Instead, officers and employees, to whom directors delegate authority, conduct all dealings with third persons.

Shareholders: Shareholders are the owners of a corporation. Other corporations, such as an LLC, or foreign individuals or foreign companies, may own a C-corporation. S-corporations aren't granted this same leeway.

Board of Directors: The Board of Directors is responsible for the corporation's management and policy decisions. There are, however, a few instances when the shareholders are required to approve the actions of the Board of Directors, such as an amendment to the Articles of Incorporation, the sale of substantially all corporate assets, or the merger or dissolution of the corporation.

Corporate Officers: Corporate officers, elected by the Board of Directors, are responsible for the day-to-day operational activities of the corporation. Corporate officers usually consist of a President, Vice-President, Secretary and Treasurer.

Number of Persons Required: In most states, one or more persons may form and operate a corporation. Some states, however, require that the number of persons managing a corporation be at least equal to the number of owners. For example, in certain states, if your corporation has two shareholders, it must also have a minimum of two directors.

Fringe Benefits: Corporations may offer employees unique, and deductible, fringe benefits. Also, a C-corporation employer can deduct the cost of a qualified educational assistance program, and employees can exclude up to $5,250 of such benefits from taxable income each year-but there is a restriction on this benefit. No more than 5% of the amounts paid by the employer may be provided for employees who are also more than 5% shareholders. Corporate-defined benefit plans often afford better retirement options and benefits than those offered by non-corporate plans.

Lower Marginal Tax Rates: C-corporations have overall lower tax rates than pass through entities like partnerships and S-corporations. Even at higher levels of taxable income, the current tax cost of operating as a C-corporation is generally lower than the tax cost of operating the same business in the form of a pass through entity. Specifically, a C-corporation will pay 15 percent Federal tax on $50,000 in profit, which is much less tax than you'd pay if that same level of profit flowed through a pass through entity to your personal tax return. The key is to avoid or reduce double taxation, which must be taken into account if you're considering a C-corporation. Also, some businesses, if formed as a C-corporation, may be viewed as Personal Service Corporations, which pay a flat 35 percent tax rate from the first dollar in profits; or Personal Holding Corporations, which pay 15 percent tax on any undistributed profits of the C-corporation (it used to be 38.9 percent). Check with your planning professional to make sure your business won't fall under one of these definitions. Especially be wary of the Personal Service Corporation-one entity that is not often discussed.

Corporate Formalities: If you want to retain the corporate existence, limited liability benefits, and special tax treatment, you must observe corporate formalities. If you're the owner of a one-person corporation, you'll find that you must wear different hats depending on the occasion. For example, as a one-person corporation, you will be responsible for being the sole shareholder, Director, and Officer of the corporation. You'll have to hold annual meetings, take (and keep) corporate minutes of the meetings, appoint Officers, and issue shares to yourself.

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Shareholder Liability for Corporate Debts: Where corporate formalities are not observed, shareholders may be held personally liable for corporate debts. So if you create a thinly capitalized corporation, commingle funds with employees and officers (using corporate funds to buy personal items and vice versa), fail to issue stock or hold meetings, or if you fail to follow other corporate formalities required by your state of incorporation, a court or the IRS may "pierce the corporate veil," and hold the shareholders (you) personally liable for corporate debts. Domiciling your corporation in Nevada will help protect your corporate veil, perhaps better than your state of operations. Typically, your Nevada Corporation would register to do business in the state of operations as a "foreign corporation."

Avoiding Double Taxation: The Corporation is taxed on its profits, and profits paid out to shareholders in the form of dividends are taxed again as dividend income on each individual shareholder's tax return. However, most small corporations rarely pay dividends. Instead, the corporation pays the owner-employees salaries and fringe benefits, both of which are deductible. The goal is to "zero out" the corporation's taxable income each year, thus negating double taxation. Keep in mind that double taxation may come into play with corporate dividends, sale of stock, and on liquidation (particularly when the corporation holds appreciated property, which is usually not advised). We recommend that you review these potential negative effects with your CPA. Typically, if your business holds assets that are expected to appreciate significantly, such as real estate, patents, or copyrights, it's best if a pass-through entity own those assets.

Duration of a Corporation: As a separate legal entity, a corporation continues indefinitely. Its existence is not affected by death or incapacity of its shareholders, officers, or directors, or by transfer of its shares from one person to another.

Right to Counsel: While a corporation cannot be imprisoned, criminal action may result in fines and penalties that could harm shareholders, officers, and other persons, which gives a corporate criminal defendant the Sixth Amendment Right to Counsel. But beware! Because a corporation faces no risk of incarceration, it has no right to appointed counsel if it cannot afford to retain private representation.

Tax Losses: Tax losses incurred by a corporation are not passed through to the shareholders. Instead, a C-corporation's net operating losses (NOLs) are used to offset corporate taxable income earned in the 2 years preceding the NOL year, or in the 20 years following the NOL year. You may be in a situation where you don't need the losses personally, and it might be more advantageous to carry them over into the following year of the C-corporation, when taking the loss will be more profitable. NOLs are only one of several factors you should consider when examining the pluses and minuses of a C-corporation for your business.

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How Corporations Are Taxed

It pays to learn the ups and downs of corporate taxation before you start your business.

Corporations are taxed differently than other business structures: a corporation is the only type of business that must pay its own income taxes on profits. In contrast, partnerships, sole proprietorships and limited liability companies (LLCs) are not taxed on business profits; instead, the profits "pass through" the businesses to their owners, who report business income or losses on their personal tax returns.

Understanding Corporate Taxation

Because a corporation is a separate legal entity from its owners, the company itself is taxed on all profits that it cannot deduct as business expenses. Generally, taxable profits consist of money kept in the company to cover expenses or expansion (called "retained earnings") and profits that are distributed to the owners (shareholders) as dividends

Tax-Deductible Expenses

To reduce taxable profits, a corporation can deduct its business expenses -- basically, any money the corporation spends in the legitimate pursuit of profit. In addition to start-up costs, operating expenses and product and advertising outlays, a corporation can deduct the salaries and bonuses it pays and all of the costs associated with medical and retirement plans for employees. To be sure you don't miss out on important tax deductions, see the Business Taxes area of Nolo's Legal Encyclopedia.

Corporate Tax Payments

The corporation must file a corporate tax return, IRS Form 1120, and pay taxes at a corporate income tax rate on any profits. If a corporation will owe taxes, it must estimate the amount of tax due for the year and make payments to the IRS on a quarterly basis -- in April, June, September and January.

Shareholder Tax Payments

The corporation's owners, if they work for the corporation, pay individual income taxes on their salaries and bonuses, like regular employees of any company. Salaries and bonuses are deductible business expenses, so the corporation deducts those costs and does not pay taxes on them.

Tax on Dividends

If a corporation distributes dividends to the owners (rare for small corporations where the owners work for the corporation), the owners must report and pay personal income tax on these amounts. And because dividends, unlike salaries and bonuses, are not tax-deductible, the corporation must also pay taxes on them. This means that dividends are taxed twice -- once to the corporation and again to the shareholders.

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Benefits of the Separate Corporate Income Tax

Although reporting and paying taxes on a separate corporate tax return can be time consuming, there are some benefits to having a separate level of taxation. Here we explain a few of them, but you should see a tax expert for a complete explanation of the pros and cons of corporate taxation as it applies to your situation. This is a very complicated area, and for some companies -- especially those that may experience losses, are involved in investing or may soon be sold -- corporate taxation can be a real disadvantage.

Retained Earnings

Often a corporation will want or need to retain some of profits in the business at the end of the year -- for instance, to fund expansion and future growth. If it does, that money will be taxed to the corporation at corporate income tax rates. Because initial corporate income tax rates (15% - 25% on profits up to the first $75,000) are lower than most owners' marginal income tax rates for the same amount of income, a corporation's owners can save money by keeping some profits in the company. (This does not apply to professional corporations, however, as they are taxed at a flat rate of 35%.) In contrast, owners of sole proprietorships, partnerships and LLCs must pay taxes on all business profits at their individual income tax rates, whether they take the profits out of the business or not.

The IRS will allow you to leave profits in your corporation up to a point: Most corporations can safely keep a total of $250,000 (at any one time) in the corporation without facing tax penalties (some professional corporations may not retain more than $150,000).

Fringe Benefits

Another benefit of forming a C corporation is that the company can deduct the full cost of fringe benefits provided to employees -- almost always including the business's owners, and the owner-employees are not taxed on these benefits. Other types of business entities can also deduct the cost of many fringe benefits as a business expense, but owners who receive these benefits will ordinarily be taxed on their value.

Double Taxation

This is something to avoid. Corporate profits after they are taxed are part of retained earnings. When the corporation pays out those earnings to the shareholder they are taxed again, the result is double taxation. One way to solve this is to zero out the corporate profits. If that is not possible you might want to discuss with your CPA if your business is earning too much in profits for a C corporation (because you do not plan to reinvest the profits for growth and expansion). Perhaps a flow through entity like LLC an taxed as an S or C corporation may be better.

Corporate Tax Brackets

2004 Corporate Income Tax Rates (for C corporations)

Over	But not over	The tax is	Of excess over
$ 0	$ 50,000	15%	0
50,000	75,000	$ 7,500 + 25%	$ 50,000
75,000	100,000	13,750 + 34%	75,000
100,000	335,000	22,250 + 39%	100,000
335,000	10,000,000	113,900 + 34%	335,000
10,000,000	15,000,000	3,400,000 + 35%	10,000,000
15,000,000	18,333,333	5,150,000 + 38%	15,000,000
18,333,333		35%	0

The corporate rate schedule neutralizes the benefit of the two lowest brackets for higher-income corporations by levying a 5% surtax on corporate taxable income between $100,001 and $335,000. Corporations which pay tax at the corporate level (C corporations) with taxable incomes of at least $335,001 but not over $10 million essentially pay a flat 34% tax. Taxable income over $10 million is taxed at 35%, but with a surtax of the lesser of $100,000 or 3% of taxable income over $15 million. Above $18,333,333, the tax rate becomes a flat 35%.

Corporations that have made an S election generally are not taxed as corporations. Instead, their net income passes through and is taxed directly to the shareholders on their personal income tax returns.

Certain personal service corporations are taxed at a flat rate of 35% regardless of the amount of their taxable income.

Salaries may offset corporate income tax. In comparing the tax advantages of operating as a partnership or sole proprietorship rather than as a corporation, remember that not all of the corporate profits will be subject to double taxation. The operators of the corporation may withdraw reasonable salaries, which are deductible by the corporation. These salaries are therefore free from tax at the corporate level (though the recipients will have to pay income tax, and both recipients and the business will have to pay FICA tax on them). In some cases, the entire net profit may be offset by salaries to the owners, so that no corporate income tax is due.

Accumulated earnings tax. 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 distributed to the stockholders as dividends. However, a corporation may not safely accumulate (retain) its earnings indefinitely. If the accumulations are not related to the reasonable needs of the business, an accumulated earnings tax of 15 percent will apply in 2003 through 2008 (previously the highest individual income tax rate before enactment of the Jobs and Growth Tax Relief Reconciliation Act of 2003) in addition to the regular corporate tax. Virtually any corporation can accumulate up to $250,000 in retained earnings without becoming subject to this tax.

Corporate Alternative Minimum Tax. Like individuals, corporations can become subject to an Alternative Minimum Tax (AMT) if they have gained the benefit of "too many" tax preference items. As of 1998, the corporate AMT will not apply to any corporation that had average gross receipts of less than $5 million for a three-year period after 1994, and this exemption continues until the corporation's average gross receipts exceed $7.5 million. For corporations that are subject to AMT, the rate is 20 percent.

C Corporation Tax Return and Due Dates

If you operate your business as a corporation, the corporation must file Form 1120, U.S. Corporation Income Tax Return (or if it qualifies, Form 1120-A, U.S. Corporation Short-Form Income Tax Return ), on an annual basis, to report income and deductions. For corporations with a calendar tax year, the due date for the annual return is March 15.

The corporation may apply for an automatic six-month extension to file its annual return by filing Form 7004, Application for Automatic Extension of Time To File Corporation Income Tax Return, by March 15. The return would then be due on September 15. If your corporation is filing for the six-month extension, it must deposit (at an authorized financial institution or a Federal Reserve Bank), whatever taxes it estimates it owes by the March 15 due date. A corporation can use a Federal Tax Deposit (FTD) Coupon (IRS Form 8109) or it can deposit the amount due electronically. If a corporation doesn't make a payment of the tax owed by the due date, it may be subject to penalties.

If your corporation uses a fiscal year rather than a calendar year, the annual corporate return must be filed by the 15th day of the third month after the end of the corporation's tax year. A fiscal year corporation is entitled to the same automatic six-month extension to file its return to which a calendar year corporation is entitled. The due date for the filing of the extension is the original due date of the return - the 15th day of the third month after the end of the corporation's tax year. The actual corporate return would then be due by the 15th day of the sixth month after the original return due date.

C corporation State Tax Returns

Keep in mind since most states have a state income tax on C corporation a corporate tax return will be due at the state level in addition to your federal tax return. Please contact our office if you have questions or would like us to file your state or federal tax returns.}

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Personal Service Corporation

A Personal Service Corporation is a C corporation that is engaged in the performance of personal services, and such services are performed by employee-owners. Personal services are defined as services performed in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting. As a C corporation, the personal service corporation files Form 1120 and pays tax on profits at the entity level. There is no one single definition of a personal service corporation in the tax code. A corporation subject to one personal service corporation rule may not be subject to all personal service corporation rules. This is because the definition of a Personal Service Corporation varies depending on which tax law is being considered.

Personal Service Corporation Tax Rates

A qualified personal service corporation is not allowed to use the graduated tax rates for C corporations. The flat tax rate is the highest marginal rate (currently 35%). The definition for a qualified personal service corporation is the highest level of any of the personal service corporation definitions. At least 95% of the stock must be owned by employees performing the personal services. This is an area that requires the expertise of your CPA.

IRS Reviewing Personal Service Corporation Tax Computations

Headliner Volume 97 August 12, 2004 The Internal Revenue Service recently began contacting corporations that do not appear to have used the applicable personal service corporation tax rate in computing their 2002 and 2003 tax liability. The taxable income of "qualified personal service corporations" is subject to a flat tax rate of 35 percent instead of the graduated rates available to most corporations. A corporation is a qualified personal service corporation if it meets both of the following tests: Substantially all of the corporation's activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and At least 95 percent of the corporation's stock is owned by employees performing services for the corporation, retired employees, the estates of employees, or other persons acquiring stock in the corporation by reason of the death of employees. Personal service corporations that receive a letter and Revenue Agent Report will have 30 days to either agree or disagree with the proposed tax increase. The tax increase will be the difference between the flat 35 percent rate and the tax shown on the original return. Taxpayers who do not agree may appeal the determination by providing a written statement that they do not agree, the reasons for disagreement, and the law or other authority that supports their position. Detailed guidance on the examination process and appeal rights is included with the letter.  For additional information on personal service corporations and corporate tax rates, refer to the following sources: Instructions for Form 1120, U.S. Corporation Income Tax Return Publication 542, Corporations

Personal Holding Corporation

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A personal Holding Company is a regular "C" corporation that derives 60 percent or more of its earnings through passive income (interest, dividends, rents, royalties, etc.), where more than 50 percent of the value of the stock is owned by five or fewer individuals. In 2003 through 2008, the personal holding company tax rate is 15 percent of the corporation's undistributed earnings (per the Jobs and Growth Tax Relief Reconciliation Act of 2003), and is in addition to the regular corporate income tax . The tax does not apply to LLCs.The tax is extremely complicated due to its many exceptions. In practice, the tax will not usually apply to small business owners. While the typical small business may be owned by five or fewer individuals, in most cases its income will not be passive, or will fall within some of the exceptions.

However, in an arrangement where a holding company and an operating company are used , the tax may very well apply to the holding company unless a consolidated tax return is filed. That consolidated return opens its own set of complications and complexities.This tax can be avoided by making a subchapter S election, since S corporations are not subject to the tax. Once again, however, with an LLC you don't have to worry about dealing with this tax, or avoiding it.

Controlled Groups- A controlled group is where you have two C corporations with common ownership. If that is the case and you fit into the below categories instead of having two separate tax brackets there would be only ONE graduated income tax bracket. That means the corporation would pay higher taxes! This is a very complicated area of tax law and should be something to keep in mind if you are forming a second C corporation.

Definition of a Controlled Group (click here)

What Is a Controlled Group?
A parent/subsidiary controlled group takes into account ownership of one entity (corporations, partnerships, and sole proprietorships) by another. Basically, if one entity owns at least 80% of the outstanding voting stock of the other, they form a parent/subsidiary controlled group. If an owner or officer of the parent entity owns at least 5% of the subsidiary, such stock is ignored in determining the percentage. Therefore, if partnership A owns 70% of the stock of company B, but one or more of the partners (or spouses) own 15% of B, then the ownership of B by A is considered to be 82% (70% divided by 85%), and a controlled group exists.

A brother/sister controlled group involves ownership of two or more corporations, partnerships, or sole proprietorships by five or less individuals, trusts, or estates who (i) have ownership interests in each entity, (ii) the total of such ownership in each entity is at least 80%, and (iii) when the lowest ownership of each individual in the entities is taken into consideration, the total for the individuals is at least 50%. Although the family attribution rules normally only require the ownership of a minor child to be considered as owned by the parents, if the parent owns at least 50%, then ownership by any child is attributed to the parent. There are instances in which spousal attribution is not required so that a husband's 80% owned company and the sole proprietorship of the wife may not be a "brother/sister" controlled group if certain conditions are met.

A combination controlled group consists of a parent/subsidiary group and a brother/sister group. It is also possible for an entity to be part of more than one brother/sister group! The factors for determining if an employer is a member of a controlled group are complex and include deciding which stock is included in the determination, the application of the family attribution rules, and foreign ownership of employers.

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See other examples:



Corporate State Tax Rates - Along with Federal Income Taxes it is very important to know the C-Corporation of the state you are conducting business. Here is a list of state tax rates (subject to change so always check with your home state).

Notice: Concerning the above tax comments, keep the following in mind:

• This is how the above tax strategy works generally.
  
• This assumes that you are running a business with an honest "expectation of profit" and "that your expenses are ordinary, necessary, reasonable and directly related to your business."
  
• You document the deductions correctly.

In Which State You Should Form Your Entity?

 

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