Fact checked for accuracy by Billie Anne Grigg, a bookkeeper and Mastery Level Certified Profit First Professional.
If you’re a small business owner or entrepreneur, it’s important to understand how corporations get taxed.
The Internal Revenue Service (IRS) taxes corporations on their profits instead of the income they pass through to shareholders.
In this article, we’ll cover how corporate taxes differ from unincorporated businesses so that you can take advantage of all available tax savings strategies for your business structure.
Types of Corporations and How They Get Taxed
Let’s review the two types of corporations and the ways they get taxed.
A C corporation is a separate, legal entity from its owners. Individuals or other corporations might become their owners.
In this type of corporation, the company gets taxed on its profits. A C corporation must report to the IRS the income and losses of the company on its Form 1120 Income Tax Return.
After paying taxes on the profits, the company distributes dividends to shareholders in proportion to their shareholdings. It might also distribute out of earnings and profits (E&P) if no funds remain available for distribution after taxes.
C Corporation Double Taxation
One disadvantage of C corporations is that they pay out tax on profits, and then shareholders must pay taxes on dividends. This means that companies can get taxed twice on their profits.
One thing to consider about double taxation is that many smaller companies don’t pay out dividends. This means their profits aren’t taxed twice when they’ve retained the earnings.
An S corporation is a pass-through entity. This means that the company doesn’t pay taxes on its profits or file any tax forms beyond the 1120S tax return. Instead, it’s the individual owners who get taxed when they receive their shares of dividends.
More specifically, profits flow through to its shareholders and get taxed on their individual tax returns at their individual income tax rates. Furthermore, an S corporation’s shareholders can claim business losses against their personal income.
This is similar to the way LLCs and partnerships get taxed.
How Taxes on Dividends Work
When any corporation provides dividends to shareholders, the IRS treats these distributions as taxable income to the shareholders. Individuals then report this income on their personal tax returns.
Every corporation must designate a board of directors before filing any forms or paying taxes. The board then must authorize and declare dividends to shareholders based on the company’s profits or E&P (the number of earnings that exceed retained earnings).
Let’s say that the board authorizes a dividend of $10,000. The company would report this on its 1120 tax return and send shareholders information reported on the 1099-DIV form. This is the case even if shareholders choose not to receive dividends or receive partial amounts distributed throughout the year. Only whole numbers get reported on the 1120s and 1099-DIV forms.
Separate Corporate Income Tax & Its Benefits
Always consult with a qualified tax professional when dealing with corporate taxes. A CPA can make sure you’re taking advantage of all available tax breaks.
You might not enjoy reporting profit and loss numbers on both a corporate return and your return. However, keep in mind that corporate tax rates are often lower than personal income tax rates. This could translate to a huge benefit for your business.
Let’s review some of the benefits of the separate corporate income tax.
Tax-Free Fringe Benefits
One of the most common fringe benefits available to employees is healthcare and transportation allowances. The corporation can provide these free from tax consequences if they meet specific requirements. For example, the company must have a written plan stating that only employees are eligible for these particular benefits.
Lower Corporate Tax Rate
New laws that started in 2018 resulted in a flat corporate rate of 21%. This is lower than the personal income tax rate.
Although double taxation can negate the benefit of this lower corporate tax rate, the corporation can still win when retaining profits in the business. In this case, money held back is only subject to the 21% tax rate.
When Corporate Taxes Are Due
All corporations must make quarterly tax payments to the Internal Revenue Service (IRS). Here are the due dates:
- April 15th
- June 15th
- September 15th
- December 15th
A C corporation must pay its annual tax return on April 15th. An S corporation does this on March 15th.
Types of Taxes Corporations Need to Pay and How They Get Calculated
The types of taxes paid by corporations vary. Consult your accountant to make sure you’re filing correctly. Here are the basics of the taxes paid by corporations.
Corporate Income Taxes
The current federal corporate income tax rate for all corporations is 21%.
State corporate tax rates vary. You’ll need to pay the state corporate tax rate based on where your company conducts business. This becomes complicated if your business operates in more than one state.
For example, if your business operates in both California and Ohio, you’ll need to pay the corporate tax rate of each state based on the portion of the profit generated in each state.
Sales taxes are a different type of tax paid by corporations. They work similarly to corporate taxes. Each state has its own unique sales tax rate. The amount of money paid in sales tax is the total revenue of all products sold, minus any discounts offered and any returns made by your customers. Note – Some states only collect sales tax on tangible products, while others tax services. Check with your state tax commission to make sure you are compliant.
Corporations pay federal employment taxes. These taxes represent a combination of the Social Security and Medicare taxes that employers typically withhold from an employee’s paycheck to cover these types of retirement benefits, as well as a portion the company is required to “chip in.” The employer remits these amounts together as one tax with the IRS.
The U.S. government requires some industries to pay special taxes on top of income, sales, and employment taxes. For example, gambling businesses have to pay a separate federal occupational tax on their earnings before they can distribute winnings to their employees.
States also levy industry-specific taxes. Corporations can’t avoid these types of taxes without risking legal action from government entities. They must accept this burden when they become incorporated businesses.
How to Pay Corporate Taxes
When a corporation decides on their final profit after deducting all expenses from revenue, they file this number away as “net income”.
It’s important to take all allowed deductions to lower the final profit number.
Here are potential deductions a corporation might qualify for.
Deductions from Revenue
Corporations qualify for deductions from revenue. These can include a percentage of the cost of food served to employees, contributions made to a state unemployment insurance fund by an employer, and donations to educational institutions that provide vocational training or better employees.
Deductions from Assets Raised
When corporations raise money by selling their assets, they can also qualify for deductions that lower the amount of money owed. For example, if a corporation holds onto an asset for one year or more before selling it at a profit, then they can take advantage of the “capital gains” deduction and use this as one of their deductions from revenue.
Deductions from Losses
Corporations can take deductions from specific losses and costs as well. This includes the deduction of a corporate officer’s or director’s salary after being returned to the corporation.
Deductions from Inventory Losses
Businesses that sell products also have to deal with inventory losses. Corporations can take deductions for all inventory lost, destroyed, or stolen throughout the year.
Deductions from Depreciation
Depreciation deductions directly affect net income. If a corporation makes an expensive purchase, it can deduct part of this cost by depreciating the item over the amount of time it intends to use it.
Deductions from Allocations
Corporations can also take deductions when they allocate money to specific business costs, such as withholding taxes on employee salaries, warranty programs, and advertising and marketing expenses. These types of allocations represent the fees a corporation pays for doing business in another country or with another branch of the same corporation.
Deductions from Capital Gains
Capital gains is a term that covers all types of profit made from capital assets, such as land or equipment. When a corporation earns a profit from selling its capital goods, it can claim this deduction and pay taxes on it.
Make sure the corporation files each quarterly tax payment on time. Penalties might accrue if you fail to make payments correctly.
The next step is to file any rebates that might apply if the corporation overpaid during the year.
Finally, use IRS Form 1120 to file the annual return.
The Last Word
You should understand that the tax filing process for corporations isn’t hard. The main thing you need to check into is how the tax law pertains to your specific company type, employee benefits paid out, business deductions, which states you’re operating in, and the final annual profit.
For this reason, it’s important to consult an accountant to help make sure you’ve crossed all the “T’s” and dotted all the “I’s”. Doing so might avoid any headaches from tax underpayments or filling out tax forms incorrectly.
Filed under: Advice Columns