How corporations are taxed

They say that you should never handle a gun before reading the instruction manual.  The same goes for owning stock in a corporation.  You must understand how they work.

I’ve written previously about the benefits of incorporating.  In this post I’d like to explain how corporations are taxed.  This should help you set up transactions – and your compensation – to minimize, or at least delay, tax payments.
S&W 629-1 3"
Before handling, read the instructions.
S&W 629-1 3″ by ~Steve Z~, on Flickr

The following discussion only applies to Subchapter-C corporations.  Corporations may elect something called Subchapter-S status, which  completely changes all of the rules.  I plan to explain  taxation of Subchapter-C corporations in a future post.

I previously explained that income from sole proprietorships and partnerships “flows” through to their owners.  Each owner pays taxes for their own individual share of income from these entities.  On the other hand, corporations pay their own taxes, and individual stockholder-owners do not need to pay taxes on corporate income.

Corporate tax rates range anywhere from 15% to 38%.  Like individuals, corporations follow the “pay as you go” system, and must pay estimated taxes each quarter, and then file a year-end tax return (Form 1120), which computes income, income taxes due, and any additional payments required or refund owed.

Here’s the bad news: corporate income is subject to double-taxation.  They are taxed at two separate levels:
  1. Corporations pay their own income taxes on taxable income.
  2. Taxable income, when distributed as dividends to owners, is usually taxable as income to the owners.  (Dividends are payments of profits to a corporation’s stockholders.)
This means that $10,000 worth of corporate income will be subject to, say, 35% corporate income tax, leaving you with $6,500* after taxes.  Now suppose that the corporation then distributes the income as dividends to its owners.  And assume the individual will pay 35% personal income tax on this income.  That leaves the taxpayer with $4,225**.  As you can see, income taxes actual eat up more than half of the actual profits.  If the corporation or individual is subject to state income taxes, then they will yield even less spending money.

Small business corporations often work around these rules by paying stockholders salary instead of dividends. The corporation is permitted to record this salary as an expense, so that it decreases taxable income and income tax expense.  Like any other salary, this income is subject to social security and medicare taxes.Some small business corporations attempt to work around these rules by paying personal expenses of their owner, such as the cost of a car lease.  This strategy doesn’t work very well because the tax authorities consider such “employee benefits” to be taxable income to the owners, just like salary.

Another way to avoid double-taxation is to simply let a corporation keep its own profits, not paying any dividends at all to stockholders.  However, this strategy may not be practical for many stockholders, who, you know, are in business to make money.

Another strategy is to elect something called Subchapter-S status.  I’ll explain this in a future post.

* 10,000 – (10,000 x 35%) = $6,500

**  $6,500 – (6,500 x 35%) = $4,225

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