Business Corporations

How It's Taxed

A business corporation may choose between two tax classifications, C or S. When a corporation is formed at the state level, it is automatically a C Corporation. To change to an S Corporation, it must meet specific requirements of a small business. These include a maximum of 100 shareholders, only one class of stock, and certain type of shareholders (primarily individuals who are not non-resident aliens, estates, and certain types of trusts).

C Corporation Taxation

In a C Corporation, losses remain with the corporation and are unable to be utilized by the shareholders. Profits are taxed at the corporation level at federal and state corporate tax rates. Shareholders who are employees primarily receive compensation that bears some relationship to the corporation’s profits but are not an actual percentage distribution of the profits as would be the case in an S Corporation where corporate profits are automatically passed through to the shareholders according to their ownership percentages.

In a small business C Corporation, there are inherent tax risks for a very profitable company. First, the tendency to reduce taxable profits by increasing compensation to key shareholder-employees raises the risk that the IRS will characterize compensation as “unreasonable” and reclassify a portion of compensation as a dividend. A dividend is taxable income to the shareholder just as salary compensation, but a dividend is not a deductible expense to the corporation. In short, this reclassification results in double taxation.

A corporation that accumulates earnings beyond the reasonable cash needs of its business may be subject to a penalty tax of 28 percent. Most corporations are not required to show special justification until they have accumulated earnings of $250,000 ($150,000 for professional corporations).

S Corporation Taxation

Many small businesses that meet the requirements elect to be taxed as an S Corporation because of its pass-through tax treatment and the resulting elimination of the C Corporation tax risks of double taxation and retained earnings tax. S corporation treatment is similar (but not identical) to partnership treatment.

An S Corporation is generally not taxed at the corporation level. As a pass-through tax entity, all profits and losses of the corporation flow through to the individual shareholder’s personal tax returns. Losses may be used to offset certain types of income from other sources. Shareholder-employees may be able to reduce their self-employment taxes by taking a portion of the corporation’s profits in the form of salary (subject to SE taxes), and receiving additional income as a distribution of profits to shareholders (not subject to SE taxes). The shareholder-employee must be able to support the salary portion as reasonable compensation.

Distributions are not taxable to a shareholder except to the extent that the money and fair market value of property distributed exceed the shareholder’s basis in his or her stock and the basis of debt owed by the corporation to the shareholder.

Choosing C or S Corporation Tax Classification:

Every corporation may change its tax classification one time within the first 75 days of its tax year. Thereafter, it must wait 5 years before another change is permitted. It is a complex decision to choose the most advantageous tax classification because the consideration involves not only the current status of the business but also its future goals and direction. In making this analysis, the following factors should be reviewed:

  • The corporation’s projected taxable income during and beyond the start-up period;
  • Its projected cash flow during the same periods;
  • Its projected corporate income tax bracket;
  • The individual income tax brackets of the shareholders;
  • The company’s plans concerning reinvestment versus distribution of earnings; and
  • The statute’s restrictions on the type and number of shareholders.


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