Just like individuals who file personal tax returns, businesses and corporate entities are also required to file tax returns with the federal government. This is how they pay their corporate taxes.
Corporate taxation applies to all different kinds of incorporated entities, including limited liability companies (LLCs), partnerships, not-for profit entities, and other associations. However, the exact tax structure that is applied depends on the nature of the entity itself. Generally, corporations, like individuals, must pay taxes on the net income or profit they receive from the work that they do. However, corporations often have the benefit of a great deal of corporate tax deductions that can greatly reduce their overall taxable income. Indeed, corporate tax deductions are so expansive that it is often worth investing in the advice of a qualified tax advisor who can help a corporation to sift through all the available tax deductions that may be available to them. Common sources include:
- Medical and retirement plans for employees
- Salaries and bonuses
- Startup costs
- Advertising costs
- Other legitimate and necessary business expenses
Corporations pay their corporate taxes via Form 1120. Additionally, unlike many individuals, corporations are often required to pay estimated tax payments on a quarterly basis in order to avoid a high tax bill at the end of the year.
Unique Forms of Corporate Taxation
In addition to paying taxes on net income or profits, corporations must also pay taxes on other means that they use to distribute income to their shareholders and owners. For instance, many corporate owners receive a portion of their payments in the form of salaries and bonuses when they perform functions on behalf of the corporation. When this happens, these payments must also be reported as personal income sources for the owners and are subject to personal income taxes.
Likewise, where corporations distribute income in the form of dividends to corporate owners, these dividends must also be reported as income. Moreover, unlike salaries and bonuses, which can be deducted as business expenses, dividends must be reported by the corporation and corporate taxes must be paid. Thus, dividends are a unique form of income that is subject to double taxation, at both the corporate and personal level.
Structuring a Corporation to Avoid Corporate Taxation
Because corporations and corporate owners can face the problem of double taxation, where income and profits are taxed at both the corporate and personal income level, there are alternative corporate forms that have been developed to minimize these difficulties. In particular, the S corporation is increasingly used by owners and individuals to minimize corporate taxes. In an S corporation, profits “pass through” the corporation and proceed to the individual owners. Thus, they are reported on the individual owner’s tax returns as personal profits, but are not reported by the corporation as a form of profit. This reduces the risk of double taxation.
While this can seem appealing to some owners, there are trade offs. Corporate profits that remain with the company are typically taxed at a rate of 15-25 percent. For some owners, this can be significantly lower than personal income tax rates. Thus, by allowing profits to pass through the company, they can actually be subjected to higher levels of taxation than if they had stayed with the corporate entity. For this reason, it is often very important for business owners to speak with a qualified business professional to determine whether S corporate status, or regular C corporate status, makes the most sense for corporate owners and shareholders.