The corporation is a separate legal entity and is subject to special rules of the Internal Revenue Code. As a separate business entity, corporations must draft articles of incorporation, draft by-laws of the corporation, elect directors of the corporation, and keep minutes of corporate meetings. These processes can be very time-consuming and very costly. However, the greatest advantage of the corporation is limited liability for the owners. The corporation is considered a legal and separate entity for its owners. If the corporation cannot pay its debts, the creditors can only go after the corporation for the payment; they cannot go after the owners. The greatest disadvantage to the corporate entity structure is double taxation. When the corporation earns income, it pays corporate taxes ranging from 15% to 39% based on 2015 tax rates. When the corporation distributes those earnings to the owners either in the form of interest, rents, or salaries, a second layer of tax is paid by the owners.
There are a number of other different tax treatments for corporations that put this type of entity at a disadvantage. One tax treatments is how corporations handle operating losses. Since a corporation is considered a separate entity from its owners, the losses from the corporation can only by used by the corporation; it cannot be passed out to its owners. Another tax treatment is long-term capital gains. In most entities, long-term capital gains get preferential treatment by being taxed at a reduced rate of 15%. This preferential tax rate is not available to corporations; the long-term capital gains are taxed at the corporate tax rate that the operating income falls into. Also relating to capital losses, capital losses can only be used to offset capital gains and not regular income. If they are not used up, the corporation has the choice of either carrying the capital loss back three years or carrying it forward five years as a short-term capital loss. A final tax differential is that charitable deductions of a corporation are limited. If you have any questions concerning the different tax treatments for a corporation, please contact a tax professional.
Owners can be employees of the corporation since it is considered a separate taxable entity. The corporation must withhold payroll taxes from its employees including owners that are employees. Thus, a shareholder who is an employee is treated as any other employee. There will be no self-employment tax issues. One advantage to corporations is that they can provide a number of fringe benefits such as health insurance coverage, medical reimbursement plans, childcare and group-term life insurance coverage to their employees without it being taxable to the employee. These fringe benefits are also available for employees who are owners without it being taxable to them.
To illustrate how a corporation works; let us look at the following example:
John Doe Corporation, Inc operating income for 2015 is $75,000.
The corporation falls into the 25% tax bracket. Therefore, its corporate income tax will be $13,750.00.
To take this example further, let us assume that John Corporation, Inc. distributes a dividend to John Doe in the amount of the entire $75,000. Let us also assume that the dividends qualify as qualified dividends. As before in the previous examples, John Doe is filing as a single taxpayer.
Qualified dividends get preferential treatment. At the time of this article, qualified dividend income could be taxed at different rates. If the individual’s taxable income falls into the 39.6% income tax bracket, the qualified dividends will be taxed at 20%; if the individual’s taxable income falls in the 25%, 28%, 33% or 35% income tax bracket, the qualified dividends will be taxed at 15%; if the individual’s taxable income falls in the 10% or 15% income tax bracket, the qualified dividends will not be taxed. John Doe’s income tax liability will be computed as follows:
To summarize, the $75,000 earned by John Doe Corporation was taxed at corporate tax rates first and then when it was distributed to John Doe, the same $75,000 was taxed at the appropriate individual tax rates. Therefore, the same $75,000 has been taxed twice.
Please note, in the example above, we demonstrated the corporation distributing the operating income in the form of dividends. As stated earlier, the corporation could also have chosen to distribute the income in a combination of wages, rents, interest or a combination of all three. The corporation also has the option of not distributing any of the operating income.
In the final article of this series, we will explore the unique nature of the S Corporation.