With the dramatic cut in the corporate tax rate to 21% by the Tax Cuts and Jobs Act, there’s been some increased interest in operating as a C corporation (a regular corporation) as opposed to a pass-through entity (a sole proprietorship, partnership, limited liability company, and S corporation).
C corporations are a business entity formed under state law and taxed in a special way.
During the government’s 2018 fiscal year, there were 2,127,673 C corporations (all such corporations are required to file returns regardless of the amount of their income). Just to provide perspective, in the same period, there were 5,128,058 S corporations and 4,239,198 partnerships (including limited liability companies filing partnership returns).
Federal income taxes
A C corporation is a separate taxpayer. It files its own tax return—Form 1120. It pays its own estimated taxes four times a year.
Being a C corporation creates a double taxation situation when it comes to distributing earnings to shareholders. Dividends paid by the corporation are not deductible. The profits used to pay the dividends are taxed to the corporation. When shareholders receive the dividends, they pay tax on them (hence the double tax). The double tax problem is eliminated when the corporation pays owner-employees in taxable compensation because such compensation is deductible by the corporation (although this entails an employment tax cost). The corporation can retain earnings, although there’s an accumulated earnings penalty if too much is retained without a good business reason.
State income taxes
In addition to federal income taxes, C corporations may also pay state income taxes. According to the Tax Foundation, 6 states—Nevada, Ohio, South Dakota, Texas, Washington, and Wyoming—don’t have a state-level corporate income tax (although some of these levy a gross receipts tax explained below). In total, however, the corporate income tax accounts for only a modest portion of state tax collections (5% of total state tax collections in Q3 2019).
Gross receipts tax
Technically, a gross receipts tax is not a corporate income tax because it is based on total revenue, without any reduction for returns, discounts, operating expenses, or certain other costs. The tax may go by different names—gross receipts tax, commerce tax, commercial activity tax, corporate activity tax, franchise tax, business & occupation tax—but it amounts to the same thing, which is a tax on gross receipts.
Some states, such as Nevada, Ohio, Texas, and Washington, only have a gross receipts tax. Two states—Delaware and Oregon—have both an income tax and a gross receipts tax.
Issues to consider
In addition to the problem of double taxation, there’s a growing threat of creeping corporate income tax. Spurred on by a U.S. Supreme Court decision a couple of years ago regarding sales tax and the expansion of the concept of “nexus,” states are looking to use this to extend their tax reach on corporations. Examples:
- Pennsylvania is using “economic nexus” for its corporate income tax effective January 1, 2020.
- Washington applies its version of a gross receipts tax if a corporation has gross receipts sourced to Washington exceeding a set amount ($285,000 in 2019) or at least 25% of its total gross receipts are sourced to Washington.
Being a C corporation to enjoy a flat 21% federal corporate income tax rate may be incentive to start a discussion of whether adopting this entity status is advisable. But be sure to factor in the state-level consequences of being a C corporation.