C Corporation Income or Loss

What Is A C Corporation?

Basically, a C corporation is a form of business viewed by the law as an artificial person. It has a legal identity separate from its owners, the shareholders. In the past, a test made up of four or five factors was applied in determining whether a business entity should be treated as a corporation for federal tax purposes. Generally, an organization would be classified as a corporation if it possessed most of the following characteristics:

• Limited liability
• Centralized management
• Continuity of life
• Free transferability of interests
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For entities formed on or after January 1, 1997, a "check the box" system applies to automatically classify certain organizations as corporations. Moreover, the federal law allows an unincorporated entity to choose to be taxed as a corporation, partnership, or sole proprietorship. Be aware, however, that some states have their own rules for classifying business entities for state tax purposes, so they may not recognize the "check the box" system.

How Is A Corporation Taxed?

For federal income tax purposes, a corporation is recognized as a separate tax-paying entity. The corporation conducts business, realizes net income or loss on its business activities, pays taxes at the 21% corporate tax rate, and often distributes the profits to its owners (the shareholders). Unlike a partnership or S corporation, a C corporation's corporate income and loss cannot "pass through" directly to shareholders.

Every corporation must file a yearly tax return, regardless of the amount of income or loss incurred, and filing ends only when the corporation has been totally dissolved. Form 1120 (or Form 1120A) must be filed by the 15th day of the 3rd month following the close of the corporation's tax year.

How Is Double Taxation Involved?

The term double taxation is often used in reference to a C corporation. This is because corporate income is taxed once to the corporation when earned and again to the shareholders when distributed to them as dividends. Therefore, the business profits are taxed twice — once at the corporate level and once at the individual level. It's important to note that the corporation does not get a tax deduction when it distributes dividends to its shareholders.

Note: Corporate income is taxed at 21%. Long-term capital gains and qualified dividends are generally taxed at 0%, 15%, or 20%, depending on the amount of the individual's taxable income. An additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.

Example(s): Assume ABC Corporation has $1,000 worth of profits and that its only shareholder, Jack, pays tax on qualifying dividends at the rate of 15 percent. The corporate tax on $1,000 worth of profits amounts to $210. The remaining $790 will incur a tax of $118.50 when distributed to Jack, leaving only $671.50 in after-tax profits. This is an effective 32.85 percent combined tax rate.

Double taxation can often be avoided in small, closely held corporations, however. This is because a small C corporation's earnings typically are paid out to its employees as wages and benefits and deducted as business expenses. Often, after expenses have been paid, there is no remaining income on which the corporation must pay taxes. Moreover, if there is income left, the company usually retains it to foster future growth rather than paying it out to shareholders in the form of dividends.

Wages paid to the employee must be based on services rendered and will be scrutinized by the IRS. In fact, the IRS will reclassify a portion of the wages as constructive dividends if they do not represent "reasonable compensation."

How Is Taxable Income Determined?

Computation of gross income for a corporation is similar to the computation of gross income for an individual taxpayer. In general, business income, gains from property transactions, interest, rents, royalties, and dividends received from other corporations are included in corporate income. Corporate business deductions also mirror those of an individual. Similarly, many tax credits are available to a C corporation. Corporate taxable income is determined by subtracting allowable deductions from gross income. Corporate taxable income is taxed at 21%.

Example(s): Assume Jones Picture Corporation had $100,000 in gross income for the year. It paid $30,000 to its president during the course of the year and also paid $20,000 in wages. In addition, it paid $10,000 for rent, $3,000 for taxes and licenses, and $2,000 for advertising. Taxable income for the year would amount to $35,000 ($100,000 income minus $65,000 deduction). Tax for Jones Picture Corporation would amount to $7,350.

What Taxes Are Unique To Corporations?

In particular, there are two additional federal taxes that might apply to a C corporation:

• The accumulated earnings tax
• The personal holding company tax
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Accumulated Earnings Tax

C corporations have the ability to accumulate earnings (profits) to fund future growth. These earnings are taxed to the corporation but avoid double taxation since they are not distributed as dividends to shareholders. However, if a corporation accumulates too much money, it is subject to an accumulated earnings tax of 15 percent on its "accumulated taxable income." The central question is whether a corporation's earnings and profits have accumulated beyond the reasonable needs of the business to foster growth, retire debt, and maintain operating needs. The tax will not apply to the extent that the corporation can demonstrate the need to accumulate such amounts for the reasonable needs of the business. For most corporations, this tax will not apply until a corporation's accumulated earnings exceed $250,000 (or the demonstrated need, if greater). For service corporations in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, this tax will not apply until a corporation's accumulated earnings exceed $150,000 (or the demonstrated need, if greater).

The purpose of this penalty tax is to discourage the use of a corporation as a vehicle to shelter its individual shareholders from personal income tax rates (regardless of whether the individual rates are higher or lower than the corporate rates in a given year). In essence, this tax forces larger corporations to distribute some dividends to shareholders.

Personal Holding Company Tax

A personal holding company tax of 20 percent is imposed on the undistributed income of certain corporations that serve as vehicles to shelter passive income. This is because a corporation should be primarily an active business operation. This law targets corporations that derive 60 percent or more of their income from investments (like royalties, dividends, and rents) and that are closely held.

How Are Losses Treated?

Unlike partnerships and S corporations, C corporations are not conduits or pass-through entities. Therefore, a shareholder cannot take advantage of a corporate loss. The loss belongs to the corporation alone. Losses may take the form of an overall net operating loss for the year or a capital loss on the sale of property during the year.

Net Operating Loss

If a corporation has an operating loss for the year (rather than taxable income), the corporation cannot deduct the current year's net operating loss (NOL). Rather, the corporation can offset this loss against income reported during future tax years (carryforward). The deduction for carried over net operating losses in any year is limited to 80% of taxable income (computed without regard to this deduction). This rule applies to tax years beginning after December 31, 2017.

Tip: Farming losses can also be reported during the two prior tax years (carryback).

Capital Loss

A corporation may deduct its capital losses only to the extent of capital gains. Unlike an individual taxpayer, it cannot offset a capital loss against ordinary income. In general, the C Corporation’s net capital losses may be deducted during a carryback period of three years and a carryforward period of five years. The corporation may carry back a capital loss to the extent that it does not increase or produce a net operating loss in the tax year to which it is applied.

For more information on the topics discussed, consult your tax professional.

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