Do you know how corporate income taxes work? Are they the same as personal income taxes? How do capital gains and dividends factor in? Read on to find out says Aron Govil.
How Corporate Taxes Work: It’s All About Business Income
For the most part, the way that corporations pay taxes is similar to how individuals pay them. Corporations can be taxed at both the federal and state levels, although some states do not charge a corporate income tax (e.g., Nevada, South Dakota, Texas, and Washington, Wyoming). The amount of money paid in taxes for a corporation equals taxable profit times a tax rate — just like an individual pays his or her taxes by multiplying taxable income and tax rate. So first we need to look at how taxable income for a corporation is determine.
What Is Taxable Income?
Let’s say that ABC Company had $100 in revenue this year, and ended up with an extra $4 after expenses. However, this money was all reinvest back into the company – there were no profits over to pay out to shareholders. In terms of taxation, everything goes on the corporate tax return as “Business Income.” It doesn’t matter what happens to that money at the end of the day – it’s still business income says Aron Govil. If you think about it, businesses are always tax on their income, regardless of whether or not they have any profit left over to distribute to owners at the end of the year. So even if your company has $50 million in revenue, but doesn’t end up with any profit at the end of the year, you’ll still owe taxes on that income.
How Do I Calculate Taxable Income?
First you have to look at whether or not your corporation is an S Corp or a C Corp. This distinction is base upon how your company was up when it first apply for corporate status – some small businesses are eligible for S Corp status straight away, while larger companies may have to incorporate as a C Corp before they’re able to do so. The difference between these types of corporations really only affects one item on your tax return: federal tax rates.
Here’s how each of them are taxed under the Internal Revenue Code (IRC):
The following tax rates are applied to your taxable income if your corporation is taxed as an S Corp:
These rates apply in full, regardless of how large or small the owner’s share of ownership explains Aron Govil. Since you only pay the taxes on what you owe, there is no need for dividends, capital gains, personal allowances (below which you don’t pay tax), etc. This is one of the main reasons why many business owners choose to organize their companies as S Corps – it takes a lot less time and complexity to file their taxes each year! However, when you consider all of the deductions that apply to C Corps, it may make sense for certain small businesses (where 100% of net income goes directly to owners) to file a C Corp instead.
How about C Corps? Well, the following tax rates apply to your taxable income:
The first $50,000 of corporate taxable income (or profits) for a C Corp is tax at the same rate as individual income. After this point, any money you make will be subject to dividends and capital gains taxes. Talk about an incentive to keep those profits in the company! The good news is that there are deductions available against the corporation’s gross revenue – just like individual taxpayers can deduct mortgage interest or work-related expenses from their incomes. In addition, S Corps cannot distribute dividends if it wants to maintain its S Corp status – so after a certain level of profit has been reach, all additional cash must go back into the company.
Conclusion:
There are several factors to consider when deciding whether you want to file your business as an S Corp (and pay less in taxes) or a C Corp (and attempt to minimize dividend and capital gain distribution) says Aron Govil. It’s important that you look at the whole picture before making this decision, since there are no take-backs once you’ve done so. Take a look at these related posts: “How to File Corporate Taxes,” “Quick Guide for Understanding Corporate Tax Forms,” and “S Corporation Overview.”