Taxation of Corporations
Obviously, I can’t summarize all of the tax law applicable to corporations in a few paragraphs. But I can give a bird's-eye view of the subject—especially as tax laws apply to small businesses.
Starting a Corporation
You can usually incorporate a business without suffering any tax effect. For example, if a sole proprietor incorporates his or her business, no tax effect should occur merely because the proprietorship has become a corporation.
Similarly, if a partnership incorporates its business,no tax effect should occur merely because the partnership has become a corporation.
You may need to consult a tax practitioner, however, in any situation that isn’t like one of the preceding examples. Here’s why: When someone contributes property to a corporation in exchange for the corporation’s stock—this is what happens when you incorporate a business—that transaction is technically an exchange. And exchanges represent taxable events /unless tax laws say otherwise/.
Fortunately, tax laws do “say otherwise” in the typical cases of a sole proprietor or partnership incorporating the business. If the people incorporating the business control the business after the incorporation—control means they own at least 80% of each class of stock in the new corporation—the transfer of property for stock that occurs during the incorporation isn’t taxable.
Obviously, the control requirement is met when a proprietor incorporates his or her business. And the control requirement is met when a partnership incorporates a partnership. In other cases, such as where you’ve got a larger group of people who are contributing property to the corporation in stages, meeting the “control after incorporation” requirement may not be quite so easy.
Let me also make one other point about incorporating a business. If a sole proprietor or partnership incorporates a business and as part of the incorporation transfers liabilities to the corporation, that transfer of liabilities may trigger taxes. Specifically, transferring liabilities as part of an incorporation triggers taxes in two cases:
Case #1: If, as part of incorporating a business, a person offloads personal debt into the corporation--such as credit card debts that stem from personal charges—all of the liabilities transferred are considered (essentially) as payment made /or boot paid/ by the corporation for the property contributed. The mechanics of how this works are beyond the scope of this short discussion. But the effect is pretty easy to describe: The exchange in this case looks to the tax man like a sale, and the person contributing the property and transferring the liabilities will probably be taxed on the liabilities contributed.
Case #2: If a person offloads more debt into the corporation than the depreciated basis of the property contributed to the corporation, the excess of the liabilities over the basis of the property gets counted as income or gain. For example, suppose someone starts a corporation solely by contributing a fully depreciated truck, and there’s a bank loan on the truck equal to $10,000. In this case, the transferred liabilities ($10,000) exceed the basis of the property contributed ($0). The person contributing the truck is taxed on the $10,000.
Corporation Income and Corporation Deductions
As a generalization, a corporation counts income and deductions the same way that a sole proprietorship or partnership does. Anytime the corporation earns or receives income, the business needs to count that income in its accounting records. Anytime the corporation incurs or pays some expense that is ordinary and necessary for its business, the business can count that deduction in its accounting records.
I should also note, however, that C corporations (in other words, regular corporations that have not made an election to be treated as a Subchapter S corporation) often can also deduct some personal expenses of employees (including shareholder employees) as business expenses even though logically the expenses aren't business expenses. For example, a C corporation can pay for employees, medical expenses and count the payment as business expenses. (The do-it-yourself incorporation kits talk more about these sorts of tax-free fringe benefits.)
How C Corporations are Taxed
Regular corporations are taxed on their income. At the time I'm writing this, for example, corporate income is taxed according to the following tax-rate schedule:
$0 to $50,000 – taxed at 15%
$50,001 to $75,000 – taxed at 25%
$75,001 to $100,000 – taxed at 34%
$100,001 to $335,000 – taxed at 39%
$335,001 to $10,000,000 – taxed at 34%
$10,000,001 to $15,000,000 – taxed at 35%
$15,000,001 to $18,333,333 – taxed at 38%
Over $18,333,333 – taxed at 35%
A corporation that makes $100,000, for example, pays a 15% tax on the first $50,000, a 25% tax on the next $25,000, and a 34% tax on the last $25,000. (If you work out the math, the corporation pays $22,750 in corporate income taxes on the first $100,000 of profit.)
Note, too, that if the corporation pays a dividend to its shareholders, those shareholders pay tax on the dividend. Corporate dividends paid by a C corporation are generally taxed at a 15% rate.
Electing Subchapter S Corporation Status
For corporations that have individual shareholders who are either U.S. citizens or permanent residents, tax laws allow the corporation and its shareholder to make a Subchapter S election. By making such an election, the corporation doesn’t pay income taxes. Rather, the shareholders each get allocated a chunk of the corporation’s income and then pay income taxes on their shares.
Suppose a corporation with two equal shareholders makes an S election, for example. If the corporation makes $100,000 in profit, the corporation doesn’t pay taxes on the $100,000. Rather, each shareholder needs to include $50,000 of the S corporation profit, on his or her tax return—and each shareholder then pays the tax on the profit.
State Taxation of Corporations
A corporation pays state income taxes on the profits it earns in a state. Suppose, for example, that a California business happens to be a Nevada corporation, but does all its business in California. In this case, the business still owes California state income tax on its profits.
If a corporation operates in multiple states, the corporation apportions its profit—usually using something called a three-factor formula. Here’s a simple example of how this works: Suppose a corporation (and it doesn’t matter whether the corporation is a C corporation or an S corporation) makes $300,000. The three-factor apportionment formula apportions one-third of the $300,000 profit, or $100,000, based on the states in which the corporation owns property. For example, if the corporation has half of its property in Nevada and half of its property in California, $50,000 of profit is apportioned to Nevada and $50,000 of profit is apportioned to California.
The apportionment formula apportions one third of the profit—another $100,000—based on the states in which the corporation sells its products or services. If the corporation makes half of its sales in California and half in Washington, for example, then another $50,000 of profit is apportioned to California and $50,000 of profit is apportioned to Washington.
Finally, the apportionment formula apportions one-third of the profit—the final $100,000—based on the payroll paid in the states where the business employs people. For example, if the corporation’s payroll is evenly split between Nevada, California, Washington and Oregon, $25,000 of profit is apportioned to each of these four states.
A quick, editorial comment: The idea of incorporating a business in another state is often touted by people who don’t understand how multistate corporate taxation works. But business owners need to understand that if a corporation owns property, employs people, or makes sales in a state, the corporation generally owes taxes to that state.
Stopping a Corporation
If a corporation stops doing business, the shareholders need to liquidate the corporation by selling all of the corporation’s assets, paying off all of the corporation’s debts, and then distributing all of the cash that’s still left over to the shareholders.
To the extent that distributions made to shareholders come from previously taxed profits, the shareholders pay regular dividend tax rates (usually 15%) on the money. After the previously taxed profits are exhausted to the extent of any capital contributed to the corporation, the shareholders get tax-free returns of capital. If the corporation distributes still more money to a shareholder—money above and beyond the previously taxed profits and the original capital contributions—those distributions are taxed at capital gains tax rates (usually 15%).
One final note: If as part of stopping business, a corporation distributes property rather than cash, the corporation recognizes a gain or loss equal to the difference between the property’s fair market value and the basis of the property to the corporation. For example, if the corporation distributes appreciated property (like real estate) to a shareholder, the corporation pays tax on the appreciation.
Some Other Notes about Corporate Tax Laws
Let me make a handful of other, final miscellaneous observations about corporate taxation:
1. In general, you will need a certified public accountant or enrolled agent to prepare a corporate tax return. The corporate tax returns (the 1120 tax return for a regular corporation and the 1120-S tax return for an S corporation) are too complicated to do by hand—even if you buy tax preparation software.
2. Corporation tax returns for both C and S corporations are due 75 days after the end of the tax year. For corporations that use a calendar year ending December 31, the “75 day clock” means that the corporate return is due on March 15—not April 15 (which is when individual tax returns and partnership tax returns are due).
3. C corporations, however, may often use a non-calendar year for their accounting. For example, a regular C corporation can often have an accounting, or “fiscal,” year that ends on the last day of any month of the year.
4. S corporations may be able to use a non-calendar year, but will want to stick with a calendar year because a non-calendar only complicates your tax accounting and means you’re paying your tax accountant more money for your tax return.