Corporate Taxation

Corporate Taxation

Corporations are governed by Subchapter C or Subchapter S of the Internal Revenue Code. Those governed by Subchapter C are referred to as C Corporations or regular corporations. Corporations governed by Subchapter S are referred to as S corporation.

US corporations which generally do not pay Federal income tax are similar to partnerships in that net profit or loss flows through to the shareholders to be reported on their separate returns. Also like partnerships, S corporations do not aggregate all income and expense items in computing net profit or loss. Certain items flow through to the shareholders and retain their separate character when reported on the shareholders returns.

Unlike proprietorships, partnerships, and S corporations, C corporations are taxpaying entities. This results in what is known as double tax effect. A C corporation reports its income and expenses on Form 1120. The corporation computes tax on the net income reported on the corporate tax return using the rate schedule applicable to corporations. When a corporation distributes its income, the corporation’s shareholders report dividend income on their own tax returns. Thus, income that has already been taxed at the corporate level is also taxed at the shareholder level.

However, if a corporation is being managed by a single shareholder who distributes all the dividends of the corporation to himself at the end of the year, might be in a favorable tax position if the business is organized as a sole proprietorship rather than a corporation. If the compensation paid to the shareholder by the corporation is found to be reasonable it may be deductible. The IRS is aware that many taxpayers use this strategy to bail out corporate profits and, in an audit, looks closely at compensation expense. If the IRS believes that compensation is too high based on the amount and quality of services performed by the shareholder, the compensation deduction of the corporation is reduced to a reasonable amount. Compensation that is determined to be unreasonable is usually treated as a constructive dividend to the shareholder and is not deductible by the corporation.

The Jobs and Growth Tax Relief and Reconciliation Act of 2003 reduced the impact of this double taxation. Before 2003 dividends received by individuals were subject to the same rates as ordinary income. JGTRRA changed the top individual rate from 38.6 percent and the rate on dividend income to 15 percent (5 percent for low income taxpayers).

This tax-favored treatment is having a marked impact on many closely held corporations. Prior to JGTRRA, the motivation was to avoid paying dividends, as they are nondeductible to the corporation and fully taxed to the shareholders. To counter this problem of double taxation, corporate profits were bailed out in a manner that provided tax benefits to the corporation. Hence, liberal use was made of compensation, loan and other lease arrangements, as salaries, interest and rent are deductible items. Both the items dividends as well as compensation have their advantages and vice-versa, the ideal is a good mix of the two approaches. Besides being attractive to shareholders, the payment of dividends helps the corporation ease the problems of unreasonable compensation, thin capitalization and meeting the arm’s length test as to rents.

While detailed comparison of sole proprietorships, partnerships, S Corporations, and C corporations as forms of doing business must be made, it is appropriate at this point to consider some of the tax and nontax factors that favor corporations over proprietorships.

Tax expense can be an important factor in determining the type of entity favorable for incorporation. Also, losses of a C corporation are treated differently than losses of a sole proprietorship, partnership or S corporation. A loss incurred by a proprietorship may be deductible by the owner, because all income and expenses items are reported by the proprietor. Partnership and S corporation losses are passed through to the partners and the shareholders and are not deductible at the entity level. However C corporation losses have no effect on the income of the shareholders. Income from a C corporation is reported when the shareholders receive dividends, C corporation losses are not reported by the shareholders.

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