There are generally two ways corporations may be taxed under the federal rules. By default, a corporation is taxed under Subchapter C of the Internal Revenue Code. However, a corporation may instead elect to be taxed under Subchapter S of the Internal Revenue Code.
The selection of a certain type of entity structure or election of a particular tax status is an individualized decision that will depend on the characteristics of the business itself and the business owner’s surrounding circumstances. In one aspect, there may be certain advantages in choosing one type of entity or tax structure over another, while there may be disadvantages in another aspect. For example, in the context of investment real estate, it is sometimes preferable for the property to be held by an LLC rather than a corporation. Whether a corporation should refrain from making the ‘S’ election and continue to be treated as a C corporation or in fact make the ‘S’ election and become subject to the rules that govern S corporations is a decision that should be guided by a qualified advisor.
What Standards Apply to C Corporations?
In order to qualify as a C corporation, the entity must meet the following requirements: (1) it must be a domestic corporation that is in existence for the tax year; (2) it must file Form 1120 annually even it does not have any business activity or profits unless it is a tax-exempt organization (in which case it must file Form 990); and (3) it must file quarterly estimated tax returns if the entity expects for its taxable income to exceed $500 during the tax year.
A C corporation may be an ordinary corporation, professional corporation, non-profit corporation, closely held corporation, public corporation, or even a single owner-shareholder corporation. A C corporation is generally taxed on its earnings on two separate occasions, once when the income is earned by the corporation and again as the earnings are distributed to the shareholders.
Under the new tax laws (“TCJA”), C corporations are now required to pay a 21% flat tax on their corporate earnings. For purposes of this example, assume the corporation’s income is $100,000. After applying the 21% rate, the net amount to the corporation is $79,000. After making distributions to the shareholder in the full amount, the shareholder pays 23.8% capital gain tax, which amounts to $18,802. As such, the total amount of taxes paid by the corporation and the shareholder may be as much as $39,802. Therefore, the combined tax rate on the $100,000 business income may be as much as 39.8%.
Capital Contributions by Shareholders
The capitalization of a corporation is initially effectuated by a shareholder who transfers money, property, or services in exchange for ownership of stock. The contribution of cash to the corporation in exchange for stock is generally not a taxable event. The amount of cash contributed by the shareholder will generally determine the shareholder’s basis of stock in the corporation.
On the other hand, transfer of property is treated as a sale to the corporation. As a result, there may be tax owed by the shareholder if the property’s adjusted basis is less than the fair market value at the time of transfer. In such instances, the shareholder’s basis of the contributed property transfers to the corporation. However, if the shareholder contributes property in exchange for stock and controls the corporation immediately after the transfer, the shareholder will generally not recognize the gain on the transfer.
The standard for control within the meaning of Section 351 of the Internal Revenue Code is met if the shareholder owns 80% or more of the total combined voting power of each class of voting stock and 80% or more of the outstanding shares of each class of nonvoting stock. This rule applies to both individuals and entities that transfer property to a corporation.
If the shareholder receives anything other than stock, such as cash or property, he would have to recognize gain to the extent of the money received plus the fair market value of the property received. However, if the corporation assumes liabilities as a result of a property transfer, it is generally not deemed as money received by the shareholder except under certain circumstances, such as if there is no legitimate business purpose for the corporation to assume the liabilities or if the liabilities assumed by the corporation are more than the shareholder’s adjusted basis in the property transferred.
Earnings and Profits
Earnings and Profits (“E&P”) are critical for measuring corporate transactions and calculating a C corporation’s taxable income. E&P is used to determine whether a distribution is a taxable dividend for the C corporation, a nontaxable return of capital to the shareholder, or a capital gain to the shareholder. As a general rule, a distribution is treated as a dividend to the extent of a C corporation’s current-year E&P. If there is no current-year E&P or the current-year E&P is depleted, the distribution will constitute a dividend to the extent of the corporation’s accumulated E&P from the prior years.
E&P should be tracked from the date of the corporation’s formation until the current tax year. If it is not tracked, it may become very difficult for even the most experienced tax specialists to backtrack (in some instances for decades) and examine all of the corporation’s records ever since its inception, including its financial statements and tax returns.
It should be noted that while some transactions may increase or decrease a corporation’s E&P, the very same transactions may have no effect on the federal income tax calculations. The opposite also holds true. For example, life insurance proceeds are not taxable to the corporation, yet they increase a corporation’s E&P. Similarly, the annual federal income tax amount is generally reduced in the E&P calculation, however, it cannot be deducted on the federal taxes.
Accumulated E&Ps are the earnings and profits that a corporation had acquired in a prior year but did not distribute to its shareholders. In the event the corporation’s E&P for the current year is less than the amount of the distributions it made during the current year, a part or all of the distributions are treated as accumulated E&P. Therefore, if the corporation does not have sufficient E&P for the current year to offset the amount of dividends it distributed to its shareholders, the difference is treated as accumulated E&P.
If the accumulated E&P is depleted (meaning it reaches zero), the remaining portion of the distribution to the shareholder reduces the adjusted basis of the shareholder’s stock. This portion is not taxable because it is deemed a return of capital. If the corporation makes nondividend distribution which exceed the adjusted basis of the shareholder’s stock, the difference is treated as a gain from a sale or exchange of property. Therefore, the shareholder would owe capital gain taxes under that scenario.
To illustrate the application of E&P, consider the following hypothetical. Sherry, a shareholder of C Corp stock, has an adjusted basis of $5,000. C Corp’s accumulated E&P was $30,000 for the prior years and $60,000 for the current year. C Corp makes a distribution to Sherry in the amount of $100,000. First, the $60,000 portion of the distribution will be treated as a dividend from the current year’s E&P. Second, the $30,000 portion will be treated as a distribution from the accumulated E&P from the prior years. The remaining $10,000 will reduce Sherry’s basis in C Corp’s stock to zero. Even though Sherry will not be taxed on the first $5,000 since it is a return of capital, Sherry will be taxed on the remaining $5,000, in addition to being taxed on the $90,000 from the current-year and accumulated E&Ps.
Accumulated Earnings Tax
One of the advantages of C corporations is that it may be allowed to withhold distributions of its earnings to its shareholders. Generally, C corporations may accumulate their earnings up to $250,000 ($150,000 for personal service corporations). If the accumulated earnings exceed the specified amount, 20% tax may be assessed on any portion that exceeds the allowed threshold unless the accumulations are for the reasonable needs of the business.
If the accumulations are for the reasonable needs of the business, the 20% tax generally will not apply. Reasonable needs include possible expansion or other reasonable business reasons. Other examples include construction of new facilities, purchasing new equipment, and acquiring another business through the purchase of stock or assets. However, granting shareholders the ability to draw personal loans from the corporation is generally not deemed a reasonable business reason.
Distributions to Shareholders
A corporation may receive profits from a variety of sources, including from sales of goods, services, and income-producing assets. Unlike S corporations, the character of the income is not retained by the shareholder of a C corporation when a distribution is made to the shareholders. For example, if a corporation receives income from rental property, the shareholder merely receives a dividend. This is significant if you consider that the capital gain rates may potentially be more favorable than the ordinary rates. Therefore, if a capital asset (e.g., real estate) is sold by the corporation, the shareholder will not be able to retain the capital nature of the asset.
If a corporation earns profits, it may retain the profits to the extent allowed under the law. Alternatively, the corporation may declare some or all of the profits as distributions to the shareholders in the form of dividends. Dividends are usually distributed in cash. There are other forms of corporate distributions including distributions of property, nondividend distributions, capital gain distributions, and distributions of stock or stock options.
The amount of dividends the corporation pays to its shareholders are not deductible by the corporation. Unlike shareholders of S corporations, shareholders of C corporations cannot deduct the losses of the corporation. Since C corporations are also taxed on the entity level, only the corporation can deduct the corporate losses.
The dividends a corporation declares to a shareholder of a C corporation stock may either be treated under the ordinary rates or the more favorable capital gain rates. The treatment will depend on whether the distribution is in the form of a qualified dividend or a non-qualified dividend. If the distribution is a byproduct of a qualified dividend (i.e., distributed from a typical corporation formed under the laws of the United States), the shareholder may pay tax on the more favorable capital gain rates. If the distribution is a byproduct of a non-qualified dividend, the shareholder may pay tax under the less favorable ordinary rates.
Note that salaries or wages paid to employee-shareholders are not considered distributions. Instead, the wages are treated as business expenses similar to the wages of the corporation’s other employees. Consequently, the wages are deductible by the corporation and taxable to the employee-shareholder. In addition, a C corporation may deduct the fringe benefits it provides to its shareholder-employee. For the shareholder-employee, the fringe benefits are tax-free.
There are special standards for distributions of property to the shareholders. If the corporation distributes property to a shareholder, the fair market value of the distributed property becomes the shareholder’s basis in the property. However, the amount of the dividend may be reduced by the amount of liabilities assumed by the shareholder, or any liability that is subject to the distributed property (e.g., mortgage). The fair market value of the property is determined by the greater of the actual fair market value of the property or the amount of liabilities assumed by the shareholder.
Distributions of property to shareholders are generally treated as sales just as when shareholders transfer property to a corporation. As such, the corporation would have to recognize a gain if the fair market value of the property exceeds the corporation’s adjusted basis in the property. For example, if the distribution includes a tractor with an adjusted basis of $20,000 and fair market value of $45,000, the corporation would have to recognize the gain of $25,000. However, if the fair market value of the property is less than the adjusted basis of the property, the corporation generally cannot recognize a loss on the distribution to the shareholder.
Distributions of stock occur when the corporation issues additional shares of its corporate stock to its shareholders. Neither distributions of stock nor stock options are generally taxable to the shareholders. However, they are also not deductible by the corporation. The distributions of stock or stock options may be deemed taxable property distributions under some circumstances, such as when the shareholder has an option to receive cash or property but chooses instead to receive stock or stock options.
Constructive distributions occur in the event that the corporation confers a benefit upon the shareholder. If such a transaction was previously categorized as an expense, it may later be reclassified as a constructive distribution. As a result, the transaction would generally be nondeductible for the corporation and taxable to the shareholder. Examples of constructive distributions include payment of personal expenses, cancellation of shareholder’s debt, unreasonable compensation, and property transfers for less than fair market value.
Where individuals are generally allowed to offset their capital losses against their other income up to a certain limit, C corporations cannot offset their capital losses against their other income. For example, let’s assume a C corporation which operates a pizza parlor had a capital loss of $20,000 in 2018 when it sold its delivery vehicle (capital asset). However, it cannot deduct the $20,000 loss from the sale of the vehicle against the profits it made from the sales of pizzas. On the other hand, if it recognized a gain in the amount of $20,000 from selling a pizza oven (capital asset), the $20,000 gain from the sale of the pizza oven would likely offset the $20,000 loss from the sale of the delivery vehicle.
As a general rule, if the capital losses exceed the capital gains for the tax year, it cannot deduct the excess losses for that year. Instead, it may only carry the losses back or forward to other tax years in order to deduct the losses from any net capital gains it had during those years. Generally, it can carry back the net capital losses to three years and carry forward to five years. Any unused portion after the five-year period will be lost.
Net Operating Losses
Net operating losses (“NOL”) occur when a corporation’s deductions are greater than its taxable income. NOL can effectively reduce the income taxes for the subsequent years. Prior to TCJA, C corporations were allowed to offset their NOL with 100% of their taxable income, subject to the two-year carryback and 20-year carryforward periods. Under TCJA, the NOL deduction is now limited to 80% of the taxable income. Subject to some exceptions, the carryback rule has been largely eliminated. However, TCJA allows for an indefinite carryforward instead of the 20-year carryforward period permitted prior to TCJA.
To illustrate the impact of TCJA in the context of NOL, suppose that a C corporation incurs $200,000 NOL in 2019 and generates $100,000 taxable income in 2020. The NOL of $200,000 for 2019 can be indefinitely carried forward to subsequent years. Since the corporation may only offset 80% of the taxable income for the 2020 tax year, it is only eligible to offset $80,000 from its $100,000 taxable income. The remaining NOL of $120,000 may not be carried back, but it may be carried forward indefinitely to offset up to 80% of the taxable income in the subsequent years.
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Author: Haik Chilingaryan is the founder and principal of Chilingaryan Law. He is an attorney, entrepreneur, published author, and commentator on TV.