What Potential Entrepreneurs Should Know

¶ … Entrepreneurs Should Know About Federal Taxes for Corporations

All corporations are subject to the corporate income tax on their net income. Taxable income is the gross income of the corporation, less the deductions allowed. Major sources of corporate income include: gross profits from sales; dividends received; interest; rents; royalties; and gains and losses. Still, there can be other factors that must also be considered in determining the corporation's income. There include: receipts that are actually contributions to capital; property distributions received by the corporation; rentals paid to shareholders of a leasing corporation; and income from a sinking fund.

Each business's tax liability is based on a graduated tax rate scale. Depending on individual factors, a corporation may also be subject to penalty taxes in addition to their regular income tax. The form of business that is operated determines what taxes must be paid. The four general kinds of business taxes are: income tax, self-employment tax, employment taxes and excise taxes. (see Appendix A)

Corporate Taxes

Most corporations must make estimated tax payments for the business if it will owe tax of $500 or more when it files its return. Form 1120-W, Estimated Tax for Corporations, is generally used to figure the estimated tax.

However, the fact that many different types of corporations exist make corporate taxes more complicated. For example, one corporation's stock may be publicly traded while only a few shareholders own another's stock. Some corporations are not-for-profit entities. In addition, there are also S Corporations and limited liability companies.

Corporations are corporations for legal purposes but treated as flow-through entities for tax purposes. This helps avoid the double taxation problem inflicted on regular corporations. The limited liability company (LLC) enjoys greater flexibility with regard to the capital structure and organization of the business.

A regular corporation (C corporation) is a separate legal entity that pays its own tax. AC corporation distributes profits to shareholders in the form of dividend distributions. Since these distributions are not tax deductible, the issue of double taxation rears its ugly head.

Taxes and Penalties

Corporations are subject to double taxation. The corporation, when reporting its earnings, must pay the first level of tax, and the second level of tax is paid when the earnings are distributed to shareholders as dividends. Each shareholder must pay taxes separately on his or her dividends. The corporation is not able to deduct the distribution of dividends.

There are many similarities in the taxation of both individuals and corporations. However, there are also many differences. One significant difference is the dividends received deduction. This condition allows corporations a deduction for a portion of the dividends received from other corporations, therefore avoiding triple taxation.

The maximum corporate tax rate is only 38%, while the maximum individual tax rate is almost 40%. This difference encourages many individuals to incorporate certain activities to take advantage of potentially lower tax rates. In an effort to put a stop to these efforts, a number of penalty taxes have been recently passed. These penalty taxes include the Accumulated Earnings Tax, the Alternative Minimum Tax and the Personal Holding Company Tax. These provisions further complicate corporate taxes.

The IRS imposes an Accumulated Earnings Tax, when the corporation retains earnings beyond the reasonable needs of the business, which is usually $250,000. AET is an additional tax on earnings that applies when a business retains earnings in an attempt to avoid the higher income taxes the owners would be subject to if the earnings were paid out to them as dividends.

The Alternative Minimum Tax is an additional tax some businesses have to pay on top of the regular income tax. When it applies, the cost can be substantial. This tax basically prevents businesses with very high incomes from using special tax benefits to pay little or no tax. The AMT rules determine minimum amount of tax that a business with a high income should be required to pay. If the business is paying at least that much because of the regular income tax, its does not have to pay AMT. However, if its regular tax falls below this minimum, it must pay the difference.

The Personal Holding Company Tax is an obligatory tax that aims to discourage the use of the corporate form to shelter the income of high tax bracket individuals from the individual tax rates. To be considered a personal holding company, a corporation has to meet two requirements: the "adjusted ordinary gross income" test and the stock ownership test. Basically, the corporation must derive 60% or more of its earnings through passive income, where five or fewer individuals own more than 50% of the value of the stock. The personal holding company tax rate is 39.6% of the corporation's undistributed earnings, and is in addition to the regular corporate income tax.

Tax Planning

For corporations, tax planning is an extremely important aspect of running a business. Tax planning involves analyzing a variety of tax options to determine when, whether, and how to conduct business transactions so that taxes are eliminated or reduced. Business owners often have the option of completing a taxable transaction by more than one method. The courts strongly support the rights of business owners to choose the course of action that will result in the lowest legal tax liability. In other words, tax avoidance is totally legal. On the other hand, tax evasion, which includes the reduction of tax through deceit, subterfuge, or concealment, is completely illegal.

In many cases, tax evasion is differentiated from tax avoidance when the IRS discovers fraudulent intent on the part of the business owner. The following are four red flags that the IRS looks for when researching possible fraud: failure to report large amounts of income, such as a shareholder's failure to report dividends; claims for improper deductions on a return, such as a corporation's large deduction for charitable contributions that cannot be proved; accounting irregularities; and improper allocation of income.

Accounting Methods and Periods

Every corporation must use a consistent accounting method, which sets rules for determining how and when to report income and expenses. The most frequently used accounting methods are the cash method and the accrual method.

Under the cash method, income is usually reported in the tax year it is received and expenses are deducted in the tax year they are paid. Under the accrual method, income is usually reported in the tax year its is earned, regardless of when payment is received, and expenses are deducted in the tax year they are incurred, regardless of when payment is made.

A good accounting system is essential to a successful business as it helps to cut costs in the long run and avoid tax problems. Estimated or approximate deductions are not acceptable to the IRS. A corporation must be able to prove all business expenses with timely and accurate records to support the amounts deducted to compute its net profit. A good accounting system is extremely helpful in this tax issue.

Taxable income is calculated on the basis of a tax year, which is an annual accounting period for keeping records and reporting income and expenses. The two forms of tax years are calendar years and fiscal years. Corporations adopting a calendar year must maintain its books and records and report its income and expenses from January 1 through December 31 of each year. A fiscal year is 12 consecutive months ending on the last day of any month except December. A tax year is a fiscal year that varies from 52 to 53 weeks.