Do Corporations Pay Federal Income Taxes?
A corporation may pay federal income taxes, depending on its tax status. If it is taxed under Subchapter C of the Internal Revenue Code, it is taxed at corporate tax rates. If it is taxed under Subchapter S of the Internal Revenue Code, it is not subject to federal income tax with narrow exceptions.
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Taxation of C Corporations
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C corporations are considered independent taxable entities, meaning that they are taxed on their income just as individuals are, although at a different rate. Generally, corporate income tax rates are higher than individual income tax rates, although because the rate schedule is complex, this is not always true. When the corporation's income, already taxed once, is distributed to shareholders in the form of dividends and to employees in the form of salaries, tax is assessed against the recipient as ordinary income.
Requirements for S Corporations
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A qualifying corporation can become an S corporation by filing Form 2553 with the IRS. A number of requirements apply -- the corporation may issue only one class of stock, may have no more than 100 shareholders, and may not have nonresident alien shareholders, for example. S corporation status will be automatically withdrawn if the corporation loses its qualifications in the middle of the tax year -- by adding a nonresident alien shareholder, for example.
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Taxation of S Corporation Income
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S corporations are not considered independent taxable entities by the IRS -- generally speaking, they are taxed like partnerships. This means that S corporation income is ignored by the IRS for corporate tax purposes, except for some types of passive income. Shareholders, however, are taxed on all corporate income every year, regardless of whether or not they receive dividends. This means that if you own 20 percent of an S corporation with $2 million in taxable income, the IRS will attribute $400,000 in taxable income to you and tax you at individual income tax rates. You may write off corporate losses on your tax return, subject to certain limitations.
S Corporation Employment Taxes
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Since many S corporations are small businesses, it is not uncommon for a shareholder to be employed by the corporation. Employee salaries are subject to Social Security and Medicare taxes, while corporate dividends are not. Accordingly, many S corporations pay their shareholder-employees low salaries and make up the difference with generous dividends. The IRS, however, requires S corporations to pay realistically high salaries to their owner-employees, and will assess Social Security and Medicare taxes against dividends if the salaries are too low.
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