A Brief Note about Corporate Taxes - C or S?

The issue of corporate taxes must always be considering when incorporating. When a new corporation applies for its EIN, the IRS classifies it as a separate legal entity - or C corporation - for tax purposes. This business files its own separate tax return on which it reports its income and expenses as an independent business. If it has income in excess of its deductible expenses, it pays its own corporate tax, and its tax rates are different from those of an individual. (Unlike many states, Nevada does not have a state income tax either for corporations or individuals.)

If the C corporation has tax deductions in excess of its income, then it must carry those losses forward to the next tax year; its shareholders cannot claim those deductions on their personal tax returns.

A C corporation is considered desirable for businesses that have considerable earned income (as opposed to passive income).

The downside of a C corp is that its shareholders may be subject to double taxation in the event of liquidation. The corporation can deduct expenses that it pays out in salary, but it cannot deduct money that it pays out in dividends. When a C corporation liquidates, it pays tax on any capital gain from the sale of its assets. It then pays out those after-tax dollars to its shareholders as a dividend. When the shareholder receives the dividend, it is taxable income to the shareholder. So tax is paid twice - first when the corporation sells the assets, and second when the shareholder receives the dividend.

Alternatively, the shareholders can elect to have their company treated like a partnership instead of a separate tax entity. This is known as an S Corporation. If the shareholders make this election, the income and expenses of the company are passed through to them, and they report them on their personal income tax return. The election is made on IRS form 2553, which must be signed by a corporate officer and each shareholder.

There are restrictions on Subchapter S elections, including the number of shareholders and the fact that shareholders must, for the most part, be individual United States citizens.

You should consult a tax professional on all matters of corporate taxes and especially before making the decision whether to elect Subchapter S status.

S Corporations are often recommended for companies that hold title to appreciating assets, such as - in a normal economy - rental properties. The pass through characteristics help to avoid the double taxation issues of C corps.

Parting Comments . . .

Corporations are a time tested tool for small business owners to limit their liability. Along with limited liability companies they are two of the most important tools for asset protection.

For information about these related areas of law, click the following links:

Asset Protection: Learn how to legally protect your assets from lawsuits, taxes, and foolish heirs.

Limited Liability Companies: The Porcupine of Asset Protection

Limited Partnerships: An effective tool for asset protection

Personal Guarantees: The Good, Bad and Ugly

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