798 / How is a corporation taxed?

Any corporation, including a professional corporation or association, is considered a C corporation, taxable under the following rules, unless an election is made to be treated as an S corporation.

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.

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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.

Corporations may also wish to consider reducing the “compensation” paid to owner-employees, as those payments (while deductible by the corporation) can be taxed at up to 37 percent (plus employment taxes) after the 21 percent corporate rate has been imposed. Dividends, while not deductible by the corporation, would only be subject to a 23.8 percent second tax upon distribution.

S corporations that convert to C corporations and find that the move was ill-advised must also be aware that there is a five-year waiting period before it can convert back to S corporation status.

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Taxable income is computed for a corporation in much the same way as for an individual. Generally, a corporation may take the same deductions as an individual, except those of a personal nature (e.g., deductions for medical expenses). A corporation also does not receive a standard deduction.

There are a few special deductions for corporations, however including a “dividends received deduction”. The 2017 Tax Act reduced the 80 percent dividends received deduction to 65 percent (for corporations that own at least 20 percent of the stock of another corporation) and reduced the otherwise applicable 70 percent dividends received deduction to 50 percent.² Prior to 2018, the deduction was equal to 70 percent of dividends received from other domestic corporations, 80 percent of dividends received from a 20 percent owned company, and
100 percent for dividends received from affiliated corporations.³ For tax years ending after 2019 a corporation may deduct contributions to charitable organizations to the extent of 25 percent of taxable income (with certain adjustments).⁴ Generally, charitable contributions in excess of the percentage limit may be carried over for five years.⁵

Prior to 2018, a corporation was also allowed a deduction for production activities. Prior to its repeal by the 2017 Tax Act, this deduction was fully phased in (in 2010), and was equal to nine percent of a taxpayer’s qualified production activities income (or, if less, the taxpayer’s taxable income). The deduction was limited to 50 percent of the W-2 wages paid by the taxpayer for the year. The definition of “production activities” was broad and included construction activities, energy production, and the creation of computer software.⁶