Thinking of launching a corporation in the coming year? While corporations offer numerous benefits, they are not without drawbacks, especially when it comes to paying taxes. As a business owner, it’s important that you do your research regarding corporate tax basics to avoid IRS penalties and maximize potential revenue for yourself and potential shareholders.
Corporations are legal entities that are separate from their owners. While corporations offer their owners some legal protections, including freedom from the business’ debts, they are typically subject to greater tax burdens than sole proprietorships and partnerships. The most prominent tax requirement is known as “double taxation,” meaning that the same money is taxed twice. Income is first taxed as it’s earned by the corporation, and is taxed again when claimed by shareholders, such as when receiving dividends.
Additionally, corporations also face a blend of conventional and corporation-only taxes at the federal level. These taxes include a corporate income tax, estimated taxes, employment taxes (including payroll, Social Security, Medicare, etc.), and, in some cases, even excise taxes when applicable. Because various factors can affect your tax requirements and deadlines, it’s important to consult with an accountant if you have questions or concerns.
Tax Deductions for Corporations
Like individual and small business-owning taxpayers, corporations can reduce their liability by taking advantage of various deductions. Typically, corporate deductions fall into three categories.
Corporate tax exemptions apply to certain income and events that are non-taxable, such as business formation. On the other hand, interest deductions apply to interest expenses incurred through certain loans and trading activities. Finally, corporations can often deduct losses suffered in the course of doing business. Some typical corporate tax deductions include operating and employee expenses, equipment costs, advertising and promotional fees.
Tax Laws by Corporation Type
Below are the most common types of corporations along with details on their unique tax requirements.
The most prevalent legal entities among large and publicly owned businesses, C corporations are taxed both as corporations and again through their owners’ profits. Currently, C corporations must pay taxes at a rate of between 15 and 38% (PDF) based on how much income they have earned.
As for shareholders who receive dividends, the tax rate will vary on whether or not the dividend is “ordinary” or “qualified.” If it is an ordinary dividend, it will be treated as regular income and subject to the individual’s regular capital gains tax rate. If it is a qualified dividend, meaning that it has met certain holding requirements, it will be taxed at a rate between 0-20%.
These tax requirements are in addition to any requirements levied by state or local taxing authorities.
Unlike C corporations, S corporations are businesses in which profits “pass through” to the owners. In other words, S corporation profits are taxed only at the individual level, and not at the corporate income level, meaning that they avoid double taxation. As an added bonus, as an S corporation owner, you may be able to divide your compensation between a regular salary and non-salary profit distributions.
As a cautionary note, however, businesses must pay their employees “reasonable” salaries before any money can be designated as corporate profits. Funds considered to be salary are subject to Medicare and Social Security withholdings, with half the contribution being provided by the worker and half by the company.
Unfortunately, not all businesses will qualify to be S corporationss. To meet this status, companies must be located within the U.S., and have no more than 100 shareholders. You can file a form with the IRS to determine whether you qualify for S corporation status.
As with C corporations, aspiring S corporations should note that certain states do levy taxes on these businesses. California, for example, levies a 1.5% tax rate on an S corporation’s net profits with a mandatory minimum of $800. Additionally, S corporations that operate in more than one state must take care to file tax returns in all their various locations.
Failing to meet any tax obligations can compromise your business in very serious ways. In addition to fines, your corporation may lose its liability protection if it fails to pay its debts. Stay abreast of federal and state laws to keep tax costs to a minimum and ensure your business stays compliant and profitable in the coming years.