If your corporation is profitable but does not pay any dividends for an extended period of time, the IRS is likely to conclude that some of the salaries paid to owners are really disguised dividends. The IRS can disallow some or all of the salary deductions, resulting in a large tax bill plus interest and penalties. If you have a corporation, your best bet is to make sure all salaries are not significantly higher than industry standards, and to pay out at least some dividends each year.
Because a corporation is a taxable entity that is separate from its stockholders, its excess profits (profits remaining after being taxed at the corporate level) are not, as in the case of unincorporated businesses and S corporations, taxed to the owners when they are earned. The profits are taxed only if and when they are distributed to the stockholders as dividends. However, a corporation may not safely accumulate (retain) its earnings indefinitely. If the accumulations are not related to the reasonable needs of the business, an accumulated earnings tax of 39.6 percent will apply in addition to the regular corporate tax. Virtually any corporation can accumulate up to $250,000 ($150,000 for service-type corporations) in retained earnings without becoming subject to this tax.
Transactions between a closely held corporation and its stockholder-owners will be closely examined by IRS agents. If corporate property is diverted to the stockholders, they will be considered to have received what is called a "constructive" or "preferential" dividend. This tax treatment is highly unfavorable, since this dividend will be taxable to the owners and will not be deductible to the corporation.
The most common type of preferential dividend received by stockholders involves the payment of personal expenses on behalf of stockholders. Typically, the corporation claims deductions for these expenses as business expenses on its income tax return, but where the expenses are clearly personal expenses, the corporation will be denied a deduction and the officer-stockholder will be deemed to have received a taxable dividend.
Stockholders are also considered to have received constructive dividends when: (1) corporate property is sold to a stockholder at less than its fair market value, (2) employee-stockholders are given unreasonably high compensation, (3) the corporation pays excess rents to shareholders for property leased by the corporation, or (4) the corporation loans the shareholder funds and there is no intention to repay the loan.
Corporate alternative minimum tax. Like individuals, corporations can become subject to an alternative minimum tax (AMT) if they have gained the benefit of "too many" tax preference items. As of 1998, the corporate AMT will not apply to any corporation that had average gross receipts of less than $5 million for a three-year period after 1994, and this exemption continues until the corporation's average gross receipts exceed $7.5 million. For corporations that are subject to AMT, the rate is 20%.
A regular corporation (also known as a C corporation) is taxed as a separate entity under the tax laws. Income earned by a corporation is normally taxed at the corporate level using the corporate income tax rates shown in the table below, and the corporation must file a Form 1120 each year to report this income.
After the corporate income tax is paid on the business income, any distributions made to stockholders are taxed again at the stockholders' tax rates as dividends. Because of these two levels of tax, a regular corporation may be a less desirable form of business than the other business entities (sole proprietorships, partnerships, limited liability companies, or S corporations). This may be true even though regular corporations are taxed at lower tax rates on their first $75,000 in income.
Because the taxation of income to sole proprietorships and partnerships is determined by the tax bracket that applies to each individual owner, a comparison of tax rates that apply to corporations and to individuals can give you some idea of which form of business would save taxes at a particular income level.
Salaries may offset corporate income tax. In comparing the tax advantages of operating as a partnership or sole proprietorship rather than as a corporation, remember that not all of the corporate profits will be subject to double taxation. The operators of the corporation may withdraw reasonable salaries, which are deductible by the corporation. These salaries are therefore free from tax at the corporate level (though the recipients will have to pay income tax, and both recipients and the business will have to pay FICA tax, on them). In some cases, the entire net profit may be offset by salaries to the owners, so that no corporate income tax is due.