Business Organization & Transactions Newsletter

Corporate Taxation

A corporation is a distinct legal entity that must pay income and other taxes separately from its shareholders. As a result, net income is potentially subject to double income taxation. Net income is taxed at the corporate level on an annual basis and taxed again at the shareholder level when corporate profits are distributed to shareholders in the form of dividends. Certain smaller domestic corporations can elect to pass the net income directly to shareholders and thus avoid double taxation by making what is referred to as an “S” election. A corporation that has not made an “S” election is referred to as a C-corporation. Upon incorporation, shareholders transfer cash or other property to a corporation in exchange for stock. At the shareholder level, no gain or loss is recognized when property is transferred to a corporation solely in exchange for stock in such corporation if the transferors are in control of the corporation immediately following the exchange. Property is construed broadly to include cash, tangible property, accounts receivable, licenses and industrial know-how. The term property does not include services, however. A shareholder who provides services in exchange for stock will be taxed on the value of the services. Control means direct ownership of stock that possesses at least 80 percent of the total combined voting power of all classes of stock and at least 80 percent of the total number of shares of each class of nonvoting stock. When a shareholder transfers property to a corporation in exchange for stock, the stock will have a cost or basis equal to the cost of the property transferred to the corporation. Example: If a shareholder transfers property with a basis or cost of $20,000 and a value of $50,000 in exchange for $50,000 worth of stock, the basis of the stock will be $20,000. If the shareholder later sells his stock for $100,000, she will have a gain of $80,000 because her basis in the stock is the basis of the property originally transferred in exchange for the stock.

S-Corporation Status Eliminates Corporate Tax

In order to eliminate the burden of double taxation, many eligible corporations will elect S-corporation status to eliminate the corporate tax. To qualify for S-corporation status, the corporation must be a small business corporation for which a subchapter S election is in effect. S elections can be made by shareholder consent every year. A small business corporation is a domestic corporation with only one class of stock and no more than 100 shareholders. Each shareholder must be an individual (other than a nonresident alien), an estate or an eligible trust. An S-corporation must not include an ineligible corporation, which could be members of an affiliated group, a financial institution or certain other entities. For purposes of the 100-shareholder limit, a husband and wife (and their respective estates) are treated as a single shareholder regardless of whether they hold the stock jointly or separately. Other joint owners are considered separate shareholders for purposes of the 100-shareholder limit. Corporations are required to file annual income tax returns. A C-corporation pays tax on its net taxable income (gross income less allowable adjustments and deductions). Generally, an S-corporation’s taxable income is passed through to its shareholders, who are then taxed on the income. A complex set of tax rules also covers corporate reorganizations, distributions, redemptions, dividends, acquisitions and liquidations. State and local tax laws must also be considered when conducting a corporate business. Additionally, foreign laws and international tax treaties must be considered for global operations. An experienced tax attorney can help a corporate taxpayer, as well as shareholders, navigate this complex area of the law.