A regular corporation (also known as a C corporation) is taxed as a separate entity under the tax laws. Income earned by a corporation is normally taxed at the corporate level using the corporate income tax rates shown in the table below, and the corporation must file a Form 1120 each year to report this income.
After the corporate income tax is paid on the business income, any distributions made to stockholders are taxed again at the stockholders' tax rates as dividends. Because of these two levels of tax, a regular corporation may be a less desirable form of business than the other business entities (sole proprietorships, partnerships, limited liability companies, or S corporations). This may be true even though regular corporations are taxed at lower tax rates on their first $75,000 in income.
Comparison with partnerships or sole proprietorships. Because the taxation of income to sole proprietorships and partnerships is determined by the tax bracket that applies to each individual owner, a comparison of tax rates that apply to corporations and to individuals can give you some idea of which form of business would save taxes at a particular income level.
The following chart compares the marginal tax rates for tax years beginning in 2001 for corporations, married individuals filing jointly, and for singles.
|$ Taxable Income||C Corp.||Married/Joint||Individual|
Note: personal service corporations (those 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) are taxed at a flat rate of 35 percent of net profits.
As the table shows, at the lower income levels (non-personal-service businesses with taxable incomes up to $75,000), corporations seem to have the advantage, but this advantage shifts the other way for income between $75,000 and $297,350. However, the rate comparison is only part of the tax picture to consider: distributions (money taken out) from a partnership are generally taxable only once on the partners' individual returns, while distributions made by a corporation to its shareholders after corporate tax is paid are taxed again as dividends on the shareholder's returns.
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 39.1 percent will apply in addition to the regular corporate tax. Virtually any corporation can accumulate up to $150,000 in retained earnings without becoming subject to this tax.
Transactions between corporations and owners. Transactions between a closely held corporation and its stockholder-owners will be closely examined by IRS agents. If corporate property is diverted to the stockholders, they will be considered to have received what is called a "constructive" or "preferential" dividend. This tax treatment is highly unfavorable, since this dividend will be taxable to the owners and will not be deductible to the corporation.
The most common type of preferential dividend received by stockholders involves the payment of personal expenses on behalf of stockholders. Typically, the corporation claims deductions for these expenses as business expenses on its income tax return, but where the expenses are clearly personal expenses, the corporation will be denied a deduction and the officer-stockholder will be deemed to have received a taxable dividend.
Stockholders are also considered to have received constructive dividends when: (1) corporate property is sold to a stockholder at less than its fair market value, (2) employee-stockholders are given unreasonably high compensation, (3) the corporation pays excess rents to shareholders for property leased by the corporation, or (4) the corporation loans the shareholder funds and there is no intention to repay the loan.
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%.