Corporate income tax and undistributed corporate income are issues for business owners and their tax attorney and/or business attorney.
Corporations have been taxed by the United States government since 1909 under the Payne-Aldrich Tariff Act. Internal Revenue Code Section 77010(a)(3) includes associations and joint stock companies within the definition of “Corporation.” Thus, federal corporate income tax is imposed on corporations that do not constitute a corporation under state law. Certain corporations known as S Corporations that are pass-through entities are not taxed at the corporate level, but rather at the shareholder level as profits, losses and other items are passed through to the individual shareholders.
Although, exceptions exist, a corporation’s taxable income is computed in very similar fashion to that of an individual. Generally, the major difficulties do not arise in computing a corporation’s taxable income or tax liability, but because, distributed income is taxable to the shareholder(s) and undistributed is not; an exchange of stock or securities may or may not lead to the recognition of gain; certain sales may actually be a dividend (disguised dividends); and, considerations regarding arm’s length transactions between a corporation and the corporation’s shareholders. These are issues that should be discussed with your tax attorney or business attorney.
The Internal Revenue Code treats corporations as independent taxpayer’s and therefore a corporation is taxed on corporate income as it is received or accrued. However, the shareholders of the corporation are taxed only when (and if) corporate distributions are made, or stock is sold. Therefore, at times, it could have been beneficial to operate as a corporation as opposed to a sole proprietorship or other entity if the corporate tax rates were less than the individual tax rates.
More current laws have increased the corporate income tax rate, and under certain sections of the Internal Revenue Code, the IRS has a variety of means by which to exploit corporate income that has been insulated or undistributed to shareholders. I.R.C. Section 482 allows the IRS to reallocate gross income, deductions, credits and other allowances between 2 or more business entities or organizations that are under common control so that income is clearly reflected. Furthermore, I.R.C. Section 531 allows an accumulated earnings tax to be imposed by the IRS on undistributed corporate income, when the failure to distribute income is deemed for the purpose of avoiding tax. Generally, the IRS would look to see if the corporation had accumulated earnings beyond the reasonable need of the corporation. Additionally, I.R.C. Section 541 imposes personal holding company (PHC) tax on undistributed income within a PHC.
Due to changes of tax rates and the above code sections, use of the C Corporation can make less sense depending upon the taxpayer’s overall circumstances. Often the choice to operate as a C Corporation is by default because the entity must operate in the C Corporate form, and/or is ineligible to make the S Election with Form 2553 and operate as an S Corporation.
This article has been drafted by John McGuire. John is a business attorney and tax attorney at The McGuire Law Firm. When deciding upon your choice of entity, or if you have questions regarding entity taxation, please feel free to contact a Denver tax attorney or business attorney at The McGuire Law Firm.