The Tax Implications of C Corporations

A C corporation is a legal entity that exists separately from

its owners and is taxed as a separate entity. As a result, C corporations are subject to double taxation: the corporation pays income tax on its profits, but the shareholders must also report their dividends on their personal income-tax returns.

Double taxation is a major disadvantage of a C corporation, and it can take a major bite out of the corporation's profits and its shareholders' dividends. But you can minimize your tax exposure if you keep a few rules in mind:

Distributing corporate profits. In small privately held corporations, shareholders may also serve as the corporation's directors and employees. Employees are entitled to salaries, and the corporation can elect to pay enough in salary and bonuses so no taxable profits remain at the end of the fiscal year. As a result, shareholders will only pay individual income taxes.

Income splitting. The government taxes the first $75,000 of corporate profits at a lower rate than the individual owners' tax rates. Therefore, you may want to split your C corporation's income between yourself and the corporation. This allows you to pay taxes on the salary you pay yourself at your individual income rate, while the profits retained in the corporation are taxed at the lower corporate tax rate.

Using the “dividends received” exclusion. C corporations can reap stock dividends from other unrelated corporations at a 30 percent tax rate. Therefore, it can be a smart move for your C corporation to invest in this manner, especially if you don’t need to take large dividends out of the company for a while.

Banking on losses. C corporations can take virtually unlimited capital and operating losses, which means the IRS will not scrutinize you if you report losses many years in a row. (The IRS is not so lenient with partnerships, sole proprietorships, and limited liability companies that declare similar losses.) You can also carry losses backward or forward and apply them against other tax years, allowing you to substantially reduce your tax bills.

Less auditing. A corporation that reports less than $100,000 of gross receipts per year is only one-third as likely to face an IRS audit as an unincorporated business with similar income. Keep in mind, however, that there is no foolproof way to avoid an audit; don't use this as an excuse to play fast and loose with tax rules.

C corporations also enjoy certain tax advantages associated with fringe benefits:

• Health insurance premiums for employees are 100 percent deductible. Sole proprietors and partnerships can only deduct 60 percent of their health insurance and long-term care insurance premiums.
• Your corporation can also implement a medical reimbursement plan that allows you to deduct medical expenses that insurance won't cover. Sole proprietors and partners cannot deduct medical expenses in this manner.

Of course, always consult your attorney and accountant to determine if you should employ specific C corporation tax strategies.