798 / How is a corporation taxed?

Graduated Tax Rates

Under the 2017 Tax Act, all corporations pay a flat income tax of 21 percent for tax years beginning after 2017 (these rates are not set to expire). There is no special rate for personal service corporations. Prior to 2018, a corporation paid tax according to a graduated rate schedule where the rates ranged from 15 percent to 35 percent.¹ A “personal service corporation” was subject to a different income tax rate prior to 2018. See Q 812.

Planning Point: The reduced corporate tax rate may encourage many business owners to explore converting from a pass-through entity (taxed at the individual’s ordinary income tax rate) to a C corporation, but caution should be exercised in making this decision. This move could potentially be beneficial for businesses that retain a significant portion of their earnings each year (whether to grow the business through asset acquisitions or simply for investment purposes). Those earnings would be taxed at the 21 percent corporate income tax rate rather than (potentially) the highest 37 percent individual tax rate that applies to pass-through income.

Despite this, when those funds are eventually distributed to shareholders, they will again be taxed as dividends (to which a maximum 23.8 percent tax may apply when considering the 3.8 percent investment income tax). The total effective tax rate works out to approximately 39.8 percent (higher than the maximum individual income tax rate). This second tax, however, can be deferred until a future date, allowing the corporation to use the funds in the meantime. In using this strategy, the accumulated earnings tax and personal holding company tax (both taxes designed to discourage corporations from retaining excess earnings beyond the reasonable needs of the business) must be considered.