How are corporations taxed?

Most types of businesses-sole proprietorships, partnerships, corporations that have qualified for subchapter S status, and limited liability companies that have not elected to be taxed as regular, or C, corporations-are pass-through tax entities. This means that all business profits and losses "pass through" the business and are reported on the individual tax returns of the owners.

For example, if a sole proprietor's convenience store turns a yearly profit of$85,000, this amount goes right on his or her personal tax return. By contrast, a regular profit corporation (and any LLC that elects to be taxed like a corporation) is a separate tax entity-meaning that the business files a tax return and pays its own taxes.

This corporate tax structure creates the possibility of double taxation-the corporation pays tax on its profit, then the owners pay tax again when those profits are paid to them as dividends. But corporate profits won't always be taxed twice. That's because owners of most incorporated small businesses are also employees of those businesses; the money they receive in the form of salaries and bonuses is tax-deductible to the corporation as an ordinary and necessary business expense. If the corporation pays surplus money to owners in the form of reasonable salaries, along with bonuses and other fringe benefits, a corporation does not have to show a profit, and therefore will pay no corporate income tax. In addition, most small corporations don't pay dividends, so there's no double taxation.

There may be tax advantages to forming a corporation. Corporations pay federal income tax at a lower rate than do most individuals for the first $75,000 of their profits-15% of the first $50,000 of profit and 25% of the next $25,000. (Professional corporations are charged a flat 35% tax rate.) By contrast, in a sole proprietorship or partnership, where the business owner(s) pay taxes on all profits at their personal income tax rates, they could pay more.

A corporation can often reduce taxes by paying its owner-employees a decent salary (which, of course, is tax-deductible to the corporation but taxable to the employee), and then retaining additional profits in the business (say, for future expansion). The additional profits will be taxed at the lower corporate tax rates. Under IRS rules, however, the maximum amount of profits most corporations are allowed to retain without an additional tax is $250,000, and some professional corporations are limited to $150,000.

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