According to IRS data, there are about 2.2 million C corporations, more than 94 % of which are small or midsize companies (with assets of $10 million or less).
For federal tax purposes, a C corporation is a separate taxpaying entity. It files its own return (Form 1120, U.S. Corporation Income Tax Return) to report its income or losses. Shareholders do not report their share of the corporation's income. The tax treatment of C corporations is explained more fully later in this chapter.
Professionals who incorporate their practices are a special type of C corporation called personal service corporations (PSCs).
Personal service corporation (PSC) A C corporation that performs personal services in the fields of health, law, accounting, engineering, architecture, actuarial science, performing arts, or consulting and meets certain ownership and service tests.
Personal service corporations are subject to special rules in the tax law. Some of these rules are beneficial; others are not. Personal service corporations:
● Cannot use graduated corporate tax rates; they are subject to a flat tax rate of 35 % (check the Supplement for a possible rate change).
● Are generally required to use the same tax year as that of their owners. Typically, individuals report their income on a calendar year basis (explained more fully in Chapter 2), so their PSCs must also use a calendar year. However, there is a special election that can be made to use a fiscal year.
● Can use the cash method of accounting. Other C corporations cannot use the cash method and instead must use the accrual method (explained more fully in Chapter 2).
● Are subject to the passive loss limitation rules (explained in Chapter 4).
● Can have their income and deductions reallocated by the IRS between the corporation and the shareholders if it more correctly reflects the economics of the situation.
● Have a smaller exemption from the accumulated earnings penalty than other C corporations. This penalty imposes an additional tax on corporations that accumulate their income above and beyond the reasonable needs of the business instead of distributing income to shareholders.
The C corporation reports its own income and claims its own deductions on Form 1120, U.S. Corporation Income Tax Return. Shareholders in C corporations do not have to report any income of the corporation (and cannot claim any deductions of the corporation). Figure 1.6 shows a sample copy of page 1 of Form 1120.
Figure 1.6 Form 1120, U.S. Corporation Income Tax Return
C corporations pay taxes according to corporate tax rates that run from 15 % on taxable income up to $50,000, to 35 % on taxable income over $15 million (with very large corporations subject to a higher marginal rate that has the effect of eliminating the graduated rates so that they are eventually taxed at a flat 35 % unless the rates are changed as noted in the Supplement) (see Table 1.1). These brackets are not adjusted annually for inflation as are the tax brackets for individuals.
There has been sentiment in Congress to significantly reduce the top corporate rate in order to make U.S. corporations more competitive with foreign corporations. According to a report by the Congressional Budget Office that compared U.S. corporate rates and other factors with those in other G20 member countries, the U.S. had the highest statutory rate, the third-highest average corporate rate, and the fourth-highest effective corporate rate. Check the Supplement for an update on corporate tax rate reduction.
Distributions from the C corporation to its shareholders are personal items for the shareholders. For example, if a shareholder works for his or her C corporation and receives a salary, the corporation deducts that salary against corporate income. The shareholder reports the salary as income on his or her individual income tax return. If the corporation distributes a dividend to the shareholder, again, the shareholder reports the dividend as income on his or her individual income tax return. In the case of dividends, however, the corporation cannot claim a deduction. This, then, creates a 2-tier tax system, commonly referred to as double taxation. First, earnings are taxed at the corporate level. Then, when they are distributed to shareholders as dividends, they are taxed again, this time at the shareholder level. There has been sentiment in Congress over the years to eliminate the double taxation, but as of yet there has been no legislation to accomplish this end other than the relief provided by capping the rate on dividends (zero for individuals in the 10 % or 15 % tax bracket; 15 % for those in the 25 %, 28 %, 33 %, or 35 % brackets; 20 % for those in the 39.6 % bracket).
In view of the favorable corporate rate tax structure (compared with the individual tax rates), certain tax penalties prevent businesses from using this form of business organization to optimum advantage.
● Personal holding company penalty. Corporations that function as a shareholder investment portfolio rather than as an operating company may fall subject to the personal holding corporation (PHC) penalty tax of 20 % on certain undistributed corporate income. The tax rules strictly define a PHC according to stock ownership and adjusted gross income. The penalty may be avoided by not triggering the definition of PHC or by paying out certain dividends.
● Accumulated earnings tax. Corporations may seek to keep money in corporate accounts rather than distribute it as dividends to shareholders with the view that an eventual sale of the business will enable shareholders to extract those funds at capital gain rates. Unfortunately, the tax law imposes a penalty on excess accumulations at 20 %. Excess accumulations are those above an exemption amount ($250,000 for most businesses, but only $150,000 for PSCs) plus amounts for the reasonable needs of the business. Thus, for example, amounts retained to finance planned construction costs, to pay for a possible legal liability, or to buy out a retiring owner are reasonable needs not subject to penalty regardless of amount.
Employees
If you do not own any interest in a business but are employed by one, you may still have to account for business expenses. Your salary or other compensation is reported as wages in the income section as seen on page 1 of your Form 1040. Your deductions (with a few exceptions), however, can be claimed only as miscellaneous itemized deductions on Schedule A. These deductions are subject to 2 limitations. The total is deductible only if it exceeds 2 % of adjusted gross income and, if your income exceeds a threshold amount that depends on your filing status, the otherwise deductible portion of miscellaneous itemized deductions is reduced by a phaseout. For 2017, the threshold amount at which itemized deductions (including miscellaneous itemized deductions) begins to phase out is $261,500 for singles; $287,650 for heads of households; $313,800 for joint filers; and $156,900