How are corporations taxed?

Takeaway: C-corporations are currently taxed at a flat 21% of income but startups have a couple unique tax characteristics. First, they typically lose money for some period of time, creating net operating losses they can carry forward against future income. Second, they typically are effectively not subject to double taxation because they reinvest all of their profits back into the business instead of distributing them to stockholders as dividends.

For startups considering or operating as a C-corporation, which is most startups, understanding the tax implications of this choice is crucial for financial planning and compliance. This post discusses the key aspects of C-corporation taxation.

Corporate Income Tax

C-corporations are considered separate tax entities by the Internal Revenue Service (IRS). This means they are subject to corporate income tax on their earnings. The corporate tax rate is a flat 21% as of the last changes implemented in the Tax Cuts and Jobs Act of 2017, applicable to taxable income.

Double Taxation

One of the most significant tax implications for C-corporations is the issue of double taxation. Unlike pass-through entities like S-corporations and LLCs, where business profits are taxed once at the individual owner's level, C-corporations' profits can be taxed twice. First, the corporation pays corporate income tax on its profits. Then, if these profits are distributed to shareholders as dividends, the shareholders must pay personal income tax on these distributions. This is what is often referred to as "double taxation."

However, many startups, particularly in the early years, reinvest all profits back into the business for growth and do not issue dividends. As a result, double taxation is usually not a concern until much later in the startup’s life cycle at which point the proceeds from a sale of the stock are probably long-term capital gains and there are other important reasons to be a C-corporation.

Capital Gains and Losses

If a C-corporation sells assets at a profit, it is subject to capital gains tax. The rate depends on how long the assets were held and other factors. On the other hand, if the corporation sells assets at a loss, it can use those capital losses to offset capital gains and reduce its tax liability.

Employee Compensation and Benefits

C-corporations can deduct the cost of employee salaries, benefits, and other forms of compensation as business expenses. This includes health insurance premiums, retirement plan contributions, and education assistance programs. However, the IRS stipulates that compensation must be "reasonable" for the services provided. If it deems compensation as excessive, it may reclassify some of it as dividends, which are not deductible.

Net Operating Losses (NOLs)

If a C-corporation's deductible expenses exceed its income for the tax year, it incurs a net operating loss (NOL). Under current tax laws, NOLs can be carried forward indefinitely to offset future taxable income. However, the deduction is limited to 80% of taxable income in a given year. This provision can be particularly relevant for startups that often operate at a loss in their early years.

Conclusion

Understanding the tax implications of operating as a C-corporation is crucial for startups. Although this entity type may pose potential drawbacks such as double taxation, it offers benefits like limited liability and ease of raising capital. As always, consult with a tax advisor to understand the best path forward for your specific situation.