The Basics of Corporation Taxation

The words “corporate taxes” raise a lot of fear and loathing in the business world. Fortunately, the reality of corporate taxation is usually less depressing than its reputation. Here are the basics. If you decide to incorporate, you’ll likely want to consult an accountant or small business lawyer who can fill you in on the fine print.

Regular Versus S Corporation

The first thing you need to know is that you’ll be treated differently for tax purposes depending on whether you operate as a regular corporation (also called a C corporation) or you elect S corporation status for tax purposes. An S corporation is the same as a C corporation in most respects, but when it comes to taxes, C and S corporations are very different animals. A regular, or C, corporation must pay taxes, while an S corporation is treated like a partnership for tax purposes and doesn’t pay any income taxes itself. Like partnership profits, S corporation profits (and losses) pass through to the shareholders, who report them on their individual returns. (In this respect, S corporations are very similar to LLCs, which also offer limited liability along with partnership-style tax treatment.) These two types of corporations are explained in more detail just below.

C Corporations

As a separate tax entity, a regular corporation must file and pay income taxes on its own tax return, much like an individual does. After deductions for such things as employee compensation, fringe benefits, and all other reasonable and necessary business expenses have been subtracted from its earnings, a corporation pays tax on whatever profit remains.

In small corporations in which all of the owners of the business are also employees, all of the corporation’s profits are often paid out in tax-deductible salaries and fringe benefits—leaving no corporate profit and, thus, no corporate taxes due. (The owner/employees must, of course, pay income tax on their salaries on their individual returns.)

Fringes and Perks

Like employee salaries, corporations can deduct many fringe benefits as business expenses. If a corporation pays for benefits such as health and disability insurance for its employees and owner/employees, the cost can usually be deducted from the corporate income, reducing a possible tax bill. (There’s one main exception: Benefits given to an owner/employee of an S corporation who owns 2% or more of the stock can’t be deducted as business expenses.)

As a general rule, owners of sole proprietorships, partnerships, and LLCs can deduct the cost of providing these benefits for employees, but not for themselves. (These owners can, however, deduct a portion of their medical insurance premiums, though it’s technically a deduction for the individuals, not a business expense.)

The fact that fringe benefits for owners are deductible for corporations may make incorporating a wise choice. But it’s less likely to be a winning strategy for a capital-poor start-up that can’t afford to underwrite a benefits package.

Tax Rates for Corporations

Initial rates of corporate taxation are comparatively low. Corporations that keep some profits in the business from one year to the next—rather than paying out all profits as salaries and bonuses—can take advantage of 15%–25% tax brackets. This practice, sometimes called income-splitting, basically involves strategically setting salaries at a level so that money left in the business is taxable only at the 15% or 25% corporate tax rate (which applies to profits up to $50,000 or $75,000). Since any amount of “reasonable” compensation to employees is deductible, corporate owners have lots of leeway in setting salaries to accomplish this.

The following chart shows tax rates for corporations. For example, if a corporation’s taxable income was $75,100, it would pay 15% of its first $50,000 of income, 25% of the next $25,000, and 34% on its remaining $100 in income. The corporation’s marginal tax rate—the tax rate a corporation would pay on the last dollar of its income—would be 34%.

Taxable Income and  Tax Rate

0 to $50,000 - 15%

$50,001 to $75,000 - 25%

$75,001 to $100,000 - 34%

$100,001 to $335,000 - 39%

$335,001 to $10,000,000 - 34%

$10,000,001 to $15,000,000 - 35%

$15,000,001 to $18,333,333 - 38%

Over $18,333,333 - 35%

Note: These corporate rates don’t apply to professional corporations, which are subject to a flat tax of 35% on all corporate income.

Double Taxation

This brings us to the vexing problem of double taxation, routinely faced by larger corporations with shareholders who aren’t active employees. Unlike salaries and bonuses, dividends paid to shareholders cannot be deducted as business expenses from corporate earnings. Because they’re not deducted, any amounts paid as dividends are included in the total corporate profit and taxed. And when the shareholder receives the dividend, it is taxed at the shareholder’s individual tax rate as part of personal income. As you can see, any money paid out as a dividend gets taxed twice: once at the corporate level, and once at the individual level.

You can avoid double taxation simply by not paying dividends. This is usually easy if all shareholders are employees, but probably more difficult if some shareholders are passive investors anxious for a reasonable return on their investments.

S Corporations

Unlike a regular corporation, an S corporation does not pay taxes itself. Any profits pass through to the owners, who pay taxes on income as if the business were a sole proprietorship, a partnership, or an LLC. Yet the business is still a corporation. This means, of course, that its owners are protected from personal liability for business debts, just as shareholders of C  corporations and members (owners) of LLCs are.

Until the relatively recent arrival of the LLC, the S corporation was the business form of choice for those who wanted limited liability protection without the two-tiered tax structure of a C corporation. Today, relatively few businesses are organized as S corporations, because S corporations are subject to many regulations that do not apply to LLCs which offer the same tax structure.  

Excerpted from The Small Business Start-Up Kit, by Peri H. Pakroo (Nolo).

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