Corporation Tax Information

            Introduction
            Federal Taxes
                        At Formation
                        During Operation
                        On Liquidation
            California Taxes
                        Franchise and Income Taxes
                        Who Pays Estimated Tax?
                        How to Compute and Pay Estimated Tax
                        Payroll Taxes

Introduction

There are also pitfalls of debt contributions. If too much of the corporation’s capitalization is from debt (from the corporation’s principals) rather than equity contributions, there is a risk that the IRS may characterize the debt contributions as really equity contributions. This means that what the corporation and the investor believed to be payments of interest will be re-characterized by the IRS as really a distribution of profits (dividends) that are not tax deductible by the corporation.

An additional risk is that a creditor may bring suit making the same argument as the IRS and asking the courts to treat the creditor’s claim as superior to the claims of the corporation’s principals.

Lastly, if the corporation has made an S election, there is a risk that too high a percentage of debt (compared to equity contributions), together with certain preference rights given to the investors, may be perceived by the IRS as really a second class of stock in violation of the eligibility requirements to be an S corporation.

Selecting the Proper Accounting Method

With certain exceptions, the IRS allows a new corporation to use any accounting method that clearly reflects its income. Any method that consistently applies “generally accepted accounting principles” in the taxpayer’s trade or business is usually acceptable to the IRS. Methods authorized in the IRC include the cash receipts and disbursements method and the accrual method.

C corporations are generally prohibited from using the cash method of accounting unless they have annual gross receipts of $5 million or less, or are “qualified personal service corporations.” A qualified PSC for this purpose is a corporation substantially all of whose activities involve performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and substantially all of the stock of which is held by employees who perform the services. Note, however, that a C corporation that begins using the accrual method cannot change to the cash method without the approval of the IRS even if it meets one of the tests for permitting the use of the cash method.

Selecting An Accounting Year

Other than S corporations and “personal service corporations,” a new corporation may elect to be taxed on either a calendar year or a fiscal year basis, provided that it regularly computes it income on that basis in keeping its books. A fiscal year is an accounting period of 12 months ending on the last day of any month. If the accounting period ends on December 31^st, it is referred to as a calendar year corporation.

An S corporation or a “personal service corporation” is required to use a “permitted tax year,” which is a calendar year in all instances unless the corporation can establish a business purpose for using a different year. The law explicitly provides that deferral of income to shareholders is not an acceptable business purpose. A “personal service corporation” is a C corporation in which the principal activity is the performance of personal services substantially by the employee-owners who own more than 10% of the corporation’s stock.

The first accounting period must begin on the date of incorporation but need not be a full 12 months. Generally, a corporation may adopt any proper taxable year without IRS approval, but approval is required for later changes. The corporation’s taxable year is established when the corporation files its first tax return.

During the Operation of the Corporation

Federal Income Tax

The net income of a C corporation is subject to taxation at the corporate level. If corporate profits after taxes are paid to the shareholders as dividends (rather than being reinvested in the business), the dividends are taxable again as income of the shareholders. The “double taxation” is one of the major disadvantages of C corporations, but it is generally easy to eliminate either by electing S corporation status or by the payment of year-end bonuses to shareholder-employees to substantially reduce or eliminate the corporation’s taxable income.

Corporations enjoy graduated income tax rates beginning at 15% for the first $50,000 and increasing to 25% for the next $25,000. The individual tax rates are higher for these income amounts, which means that a tax savings can occur if taxable income will be retained and reinvested in the business and not distributed to shareholders as dividends.

Alternatively, shareholders may elect to be an S corporation and automatically have the corporation’s taxable income passed through to them proportionately to their ownership interests. The corporation pays no federal income tax. It is instead paid by each shareholder on the amount of his share of profits, whether or not a distribution of such profits was actually made to the shareholder.

A personal service corporation is subject to a flat 35% tax on the taxable income of the corporation. This is a higher overall rate than would be paid by the individual shareholder(s) since individual tax rates are graduated, not flat rates, and the maximum rate is 38.6% for 2002 and 2003. It drops to 37.6% for 2004-2005, then drops again to 35% for 2006 and after. All of these rates are subject to any further legislative changes that may subsequently occur. It is therefore advantageous for personal service corporations to make “S” elections to avail themselves to the graduated individual tax rates and avoid the imposition of the 35% flat tax that would apply if they remained C corporations.

Estimated Tax Payments

Generally, a corporation must make installment payments of estimated tax if it expects its estimated tax to be $500 or more. If the corporation does not pay the installments when they are due, it may be subject to an underpayment penalty.

Installment payments are due by the 15^th day of the corporation’s 4^th, 6^th, 9^th and 12^th months of the corporation tax year.

Federal Payroll (Withholding) Taxes

Federal payroll taxes consist of a Social Security Tax, a Medicare Tax and an unemployment tax. The unemployment tax is paid annually while the other taxes are withheld from the paychecks of employees and paid monthly or quarterly.

The Social Security Tax is a combined 12.4%, half of which is deducted from the employee’s wages and half of which is a matching contribution by the employer. In 2003, the maximum amount subject to the Social Security Tax is $87.000.

The Medicare Tax rate is 2.9% with no limit on the amount subject to the tax. It is also split equally between the employee and the employer.

Payments and Distributions to Shareholders

The principals of a new corporation have a number of ways to enjoy the economic benefits of their business:

• As salary or other economic benefits attributable to employment

• As rental payments for real or personal property leased to the corporation

• As interest or return of principal on loans made to the corporation, and

• As dividends on shares

The interests of the corporation and the individual investor may differ with some benefits and be compatible with others. For example, while the repayment of principal is tax-free to the investor, it provides not tax benefit to the corporation. Conversely, the payment of interest on a loan is tax deductible by the corporation, but is ordinary income to the investor.

Salary payments, on the other hand, may be compatible to both interests since they are deductible to the corporation and do not require pro rata payments to other investors as dividend payments do. The risk in a small corporation is in providing good salaries and fringe benefits to shareholder-employees while paying no dividends. The IRS may view excessive compensation of such employees as disguised dividends. First, salaries must be paid for services actually rendered to the corporation. Next, the salaries must be reasonable. The factors considered by the IRS in determining the reasonableness of a salary payment include:

A Word About Deductions

Generally speaking, a corporation’s taxable income is calculated by subtracting from its gross income the deductible business expenses. To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary. If an expense is partly business and partly personal, the personal part must be separated in calculating the deductible expense. A common example is the use of an automobile for both business and personal use.

Not all business expenses can be deducted in the year in which they are incurred. Some costs must be capitalized rather than deducted. These costs are investments in the business and are called “capital expenses.” Capital expenses must be depreciated or amortized over a period of years according to a specified recovery period for the type of asset or expense. In general, there are three types of costs that must be capitalized:

• Going into business

• Business assets

• Improvements

The costs of getting started in business, before business operations have actually begun, are capital expenses. These costs may include expenses for advertising, travel, wages for training employees, and the cost of incorporating or forming another type of business.

The cost of any asset used in your business is a capital expense. There are many different types of business assets, such as land, buildings, machinery, furniture, vehicles, patents and franchise rights.

The cost of making improvements to a business asset are capital expenses, if the improvements add to the value of the asset, appreciably lengthen the time you can use it, or adapt it to a different use. Examples include new electric wiring, a new roof or floor, new plumbing, and lighting improvements.

Particular Tax Problems of Corporations

Taxes on Liquidation of the Corporation

A shareholders disposition of shares of corporate stock generally constitutes a taxable event. Gain or loss is recognized based on the difference between the amount received for the stock and the shareholders’ basis in the stock. The gain or loss will generally be treated as resulting from the disposition of a capital asset, thus being a capital gain or loss. With capital gain currently taxed for federal purposes at a maximum rate of 28 percent, and with the top marginal rate on ordinary income currently taxed at 38.6%, the treatment of gain as capital gain to upper income shareholders is potentially significant. The treatment of loss as capital loss is also significant because of the limitations on the deduction of capital loss.

Section 1244 Stock

Internal Revenue Code §1244 and its California counterpart, Rev & T C §§18206-18210 (as well as the corresponding laws of certain other states in which shareholders may reside), provide a safeguard for equity investors in a new small business enterprise. In general, an initial investor whose investment complies with the conditions of these statutes and who later realizes a loss on his or her shares may treat it as an ordinary loss rather than a capital loss, with potentially greater tax benefits.

The corporation does not have to adopt a “plan,” make an election or filing, or take any other formal steps to make IRC §1244 available to qualified shareholders. It is either available to them or not, depending on the facts concerning the company, the share issuance, and the particular investor (see summary of requirements below). No choice between tax benefits is required. There is no disadvantage to a corporation or to an investor by coming within §1244; it is always desirable. If a share issuance meets §1244 requirements, a statement to that effect in the minutes of the first meeting of the board of directors may be useful as a reminder.

As a general matter the availability of §1244 (and its California counterpart) can be summarized as follows:

• At the time the shares are issued, the corporation must be a “small business corporation,” i.e., a corporation whose total equity capital (including amounts and assets obtained through this and earlier stock issuances) does not exceed $1 million.

• For the five previous taxable years (or the total life of the corporation, if less than five years), the corporation must have either (1) operated at a loss, or (2) derived more than half its gross receipts from sources other than rents, interest, dividends, annuities, royalties, and dealings in stocks or securities.

• The shareholder must be the initial holder of the shares, not a transferee, and must be an individual or partnership (not including a trust or an estate). Thus, §1244 may be available to some shareholders and unavailable to others.

• The shareholder must have paid for the shares in money or other property, excluding stock and securities; and

• The total amount treated as §1244 ordinary loss may not exceed $50,000 annually per taxpayer ($100,000 for a married couple filing a joint return). This annual limitation is not computed separately for each corporation for which a loss is sustained, but is a cumulative limit on the particular taxpayer for all §1244 losses realized during the taxable year; any excess can be treated as capital loss (the benefits of which may be limited).

An investor will lose the benefit of IRC §1244 if the shares are purchased through a trust, an estate, a family corporation, or a nominee. Similarly, an original investor who buys shares in the investor’s own name, without forethought as to the estate planning aspects, and then transfers some of the shares to his or her children, forfeits the potential benefit of §1244 as to the transferred shares.

            

California Taxes

Franchise and Income Taxes

Corporations in California, whether formed in California or merely doing business in the state, whether active or inactive, are subject to California tax liability.  In addition to any property tax and other miscellaneous state taxes, a corporation must usually pay

A corporation pays a franchise tax “for the privilege of exercising its corporate franchises within the state” (CA Revenue and Taxation Code §23151(a)).  The corporation estimates its tax liability by multiplying its state net income by the appropriate tax rate.  There is, however, a minimum franchise tax, so a corporation must pay a franchise tax even if it generates no income or operates at a loss.  If the corporation’s estimated tax exceeds the statutory minimum, it is typically paid in quarterly installments.

A corporation pays California income tax on income “derived from sources within this state …” (Rev&T C §23501(a)).  If a corporation is subject to both the franchise tax and the income tax, then the franchise tax is credited against any income tax liability (R&T C § 23503).  Income tax is estimated based on a corporation’s net income in the same way that the franchise tax is estimated, using the same tax rate.  Unlike the franchise tax, however, there is no minimum income tax.

Changes in Franchise Tax Payments Beginning January, 1, 2000

In July 1999, Assembly Bill 10 was passed.  This new statutory provision exempts newly formed corporations from the minimum franchise tax for the corporation’s first taxable year (Rev&T C §23153(f)(1)).

Who Pays Estimated Taxes?

* This may be an oversimplification in some cases.  Corporations should complete the worksheets included in the Instructions for 2001 Form 100-ES.  The estimated tax may also be revised any time during the taxable year.

If a corporation’s estimated tax does not exceed the minimum franchise tax amount of $800, the entire amount of the estimated tax (in this case, the minimum $800) is due and payable on or before the 15^th day of the 4^th month of the corporation’s taxable year (R&T C § 19025(a)). For example, a calendar year corporation is required to make its first estimated tax payment by April 15 each year.

If, however, the estimated tax does exceed the minimum franchise tax amount of $800, the estimated tax is payable in four installments (R&T C § 19025(b)).  The installments are due and payable on the 15^th day of the 4^th, 6^th, 9^th, and 12^th month of the taxable year.  The amount of each quarterly installment is equal to at least 25% of the total estimated tax amount (id.), and the first installment must be at least the amount of the minimum franchise tax ($800).

Of course, if a business incorporates later than the first day of its fiscal year, it will have an accounting period of less than 12 months.  So-called “short accounting periods” have slightly different installment requirements, according to the following table (fiscal years will adjust the dates accordingly):

25%

Table 1

In its first taxable year, since the corporation is not subject to the minimum franchise tax, the estimated tax is payable quarterly without regard to any required minimum first payment.

There are two important points to remember for California corporations formed after January 1, 2000: First, there is no minimum franchise tax obligation for the corporation’s first taxable year, that is, its year of incorporation. Second, every new corporation is required to make quarterly estimated tax payments by specified dates during its first taxable year if it reasonably anticipates that it will have taxable income during its first year of operation.

Payroll Taxes

California payroll taxes include two taxes paid by the employer and two taxes withheld from an employee's paycheck. Employers pay Unemployment Insurance (UI) taxes and Employment Training taxes (ETT), while the employee pays State Disability Insurance (SDI) and Personal Income Tax (PIT).

When wages exceeding $100 have been paid in a calendar quarter, you are an “employer” in California and must comply with payment, withholding and reporting requirements. The first responsibility of the business is to register with the Employment Development Department (EDD) to obtain an employer account number. For commercial employers, this is done by submitting the form DE-1 registration form. Our Resource Center has a link to take you directly to the online form of the EDD.

          The rates for 2003 are as follows:         

Employer

Employers use Form DE 8 to pay employer taxes and withholding deposits from employees. A preprinted booklet and envelopes is sent to employers about four weeks after they register and obtain an employer account number.

Form DE 6 is a quarterly report that must be completed by employers and sent to the EDD to report wages paid to employees and the California PIT withheld. This form is automatically sent to employers each quarter.

Beginning January 1, 2001, the EDD added a requirement that any business that is required to file Federal Form 1099 MISC must also report specific information to the EDD regarding the independent contractor services (EDD Form DE 542). Since 1998, employers have also been required to file EDD Form DE 34 to report the hiring of new employees.