C Corporations are considered a separate entity apart from the members and shareholders and, as a result, are taxed separately. How C Corporations are taxed is provided for by subchapter C of the IRS Code, hence the reason why what we consider to be normal corporations C Corporations.
Since corporations are taxed at the entity level and also at the shareholder level, C Corporations are sometimes said to have the unfortunate result of being double taxed. This is why some corporations choose to instead be treated as an S Corp (if it meets the requirements) for tax purposes since there is no corporate level taxation and it instead passes through to the shareholders. While this may seem like the more beneficial of the two corporate forms for tax purposes, there are ways that the double taxation can be minimized and may actually turn out to be better than an S Corp form.
First, consider not all profits of a corporation are taxed at the corporate level. Salaries paid to the owner-employees of the corporation and can be deducted from the profits and are therefore not taxed. Salaries to owner-operators can eliminate corporate income tax entirely. Be careful to make sure that salaries paid are not higher than industry standard as the IRS may investigate you for attempting to avoid corporate income taxes at the corporate level. The owner-employees that are paid the salary will of course have to pay income taxes on their individual tax returns.
Paying of fringe benefits is another way to reduce the tax burden since the cost of providing things like life insurance, medical benefits and dependent care can be deducted from its tax liability and is not taxable to the employees who receive them, either.
So where does the double taxation come in? C Corporations are first taxed on profits that it makes in almost the same way a person pays taxes on their pay. This is the first level of taxation. C Corporations use a Form 1120 to report income. This form requires a lot of information and a tax professional is recommended to assist in filling it out and filing it to make sure it is done correctly. Also, if a C Corporation expects that it will owe taxes, it must make an estimate as to how much it will owe and pay the IRS quarterly. Whatever money left over after the profit is taxed is called “profit after tax” or PAT.
C Corporations can do two things with PAT. The first option is to retain the earnings. C Corporations can keep up to $250,000 of profits without paying tax penalties, so long as those retained funds are going to be used for business related purposes, such as for plans for business expansion or other capital investment, like research and development. Because this is a way to avoid the double taxation issue, it’s a good idea to document those business plans by having them reviewed and adopted by the Board of Directors in case the IRS wants proof for the business basis of retaining the money.
The second option for those earnings is to distribute it to the shareholders as dividends, which is called a distribution. This is where the issue of double taxation comes in. When a C Corporation pays dividends to its shareholders, that money distributed will be taxed at both the corporate level and at the shareholder level as the shareholders receiving that money as a dividend must report it on their own personal tax returns and are taxed as ordinary income. If a C Corporation pays out dividends, it issues a Form 1099 Dividend to its shareholders. The shareholders then use the information from the 1099 Dividend to report that income on Schedule B of their return.
C Corporations can also make distributions as stock dividends, not as money. Stock dividends are usually not taxable, however, they can be if the shareholders are given a choice between cash and stock. Some C Corporations decide to not issue dividends to shareholders to prevent double taxation. Also, dividends can’t be deducted from taxable income like money paid out as salaries. Although not paying dividends seems like an easy way to avoid paying taxes twice, the IRS will be suspicious of a C Corporation that goes too long without paying dividends as it could be seen as a way of disguising dividends being issued as salaries.