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It pays to learn the ups and downs of corporate taxation before you start your business.

Corporations are taxed differently than other business structures: a corporation is the only type of business that must pay its own income taxes on profits. In contrast, partnerships, sole proprietorships and limited liability companies (LLCs) are not taxed on business profits; instead, the profits “pass through” the businesses to their owners, who report business income or losses on their personal tax returns.

Understanding Corporate Taxation

Because a corporation is a separate legal entity from its owners, the company itself is taxed on all profits that it cannot deduct as business expenses. Generally, taxable profits consist of money kept in the company to cover expenses or expansion (called “retained earnings”) and profits that are distributed to the owners (shareholders) as dividends.

Tax-Deductible Expenses

To reduce taxable profits, a corporation can deduct its business expenses – basically, any money the corporation spends in the legitimate pursuit of profit. In addition to start-up costs, operating expenses and product and advertising outlays, a corporation can deduct the salaries and bonuses it pays and all of the costs associated with medical and retirement plans for employees.

Corporate Tax Payments

The corporation must file a corporate tax return, IRS Form 1120, and pay taxes at a corporate income tax rate on any profits. If a corporation will owe taxes, it must estimate the amount of tax due for the year and make payments to the IRS on a quarterly basis – in April, June, September and January.

Shareholder Tax Payments

The corporation’s owners, if they work for the corporation, pay individual income taxes on their salaries and bonuses, like regular employees of any company. Salaries and bonuses are deductible business expenses, so the corporation deducts those costs and does not pay taxes on them.

Tax on Dividends

If a corporation distributes dividends to the owners (rare for small corporations where the owners work for the corporation), the owners must report and pay personal income tax on these amounts. And because dividends, unlike salaries and bonuses, are not tax-deductible, the corporation must also pay taxes on them. This means that dividends are taxed twice – once to the corporation and again to the shareholders.

S Corporation Taxes

The scheme of taxation described in this article applies only to regular corporations, called “C corporations.” By contrast, a corporation that has elected “S corporation” status pays taxes like a partnership or limited liability company (LLC): All corporate profits or losses “pass through” the business and are reported on the owners’ personal income tax returns.

Benefits of the Separate Corporate Income Tax

Although reporting and paying taxes on a separate corporate tax return can be time consuming, there are some benefits to having a separate level of taxation. Here we explain a few of them, but you should see a tax expert for a complete explanation of the pros and cons of corporate taxation as it applies to your situation. This is a very complicated area, and for some companies – especially those that may experience losses, are involved in investing or may soon be sold – corporate taxation can be a real disadvantage.

Retained Earnings

Often a corporation will want or need to retain some of profits in the business at the end of the year – for instance, to fund expansion and future growth. If it does, that money will be taxed to the corporation at corporate income tax rates. Because initial corporate income tax rates (15% – 25% on profits up to the first $75,000) are lower than most owners’ marginal income tax rates for the same amount of income, a corporation’s owners can save money by keeping some profits in the company. (This does not apply to professional corporations, however, as they are taxed at a flat rate of 35%.) In contrast, owners of sole proprietorships, partnerships and LLCs must pay taxes on all business profits at their individual income tax rates, whether they take the profits out of the business or not.

The IRS will allow you to leave profits in your corporation up to a point: Most corporations can safely keep a total of $250,000 (at any one time) in the corporation without facing tax penalties (some professional corporations may not retain more than $150,000).

Fringe Benefits

Another benefit of forming a C corporation is that the company can deduct the full cost of fringe benefits provided to employees – almost always including the business’s owners. For example, a corporation can adopt a health plan and pay 100% of its employees’ insurance premiums. These costs are tax deductible to the corporation.

This provides shareholders with a slight edge over other types of business owners: limited liability companies, partnerships and sole proprietorships are not allowed as many fringe benefit deductions. For instance, sole proprietors and owners of partnerships and LLCs can deduct only 60% of their health insurance premiums in the year 2001. (However, this limit will increase to 70% in the year 2002, and by the year 2003 and beyond, these owners will be able to deduct the full cost of their health insurance premiums.)

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