Corporate Taxation

A corporation is a separate legal entity that must pay income and other taxes separate from its shareholders. As a result, net income is potentially subject to double income taxation. Net income of subchapter C corporations 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. The effects of this double taxation have been reduced by the 2003 tax act, redefining dividends as capital gains, which are taxed at a lower rate.

Generally, an entity becomes a corporation by filing articles of incorporation with the appropriate state agency governing business corporations. However, some business entities will also be classified as corporations for tax purposes even if they have not officially incorporated if they have the following characteristics:

• associates,
• an objective to carry on business and divide the gains derived from the business,
• continuity of life,
• centralized management,
• limited liability, and
• free transferability of interest.

Upon incorporation, shareholders transfer cash or other property to a corporation in exchange for stock. The tax code reflects a long-standing policy that the incorporation of a business should generally be tax free to both the shareholders and the corporation. 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 after the exchange. Property is construed broadly to include cash, tangible property, accounts receivable, licenses, and industrial expertise. The term property does not include services. A shareholder who provides services in exchange for stock will be taxed on the value of the services. Control means direct ownership of stock possessing at least 80% of the total combined voting power of all classes of stock and at least 80% of the total number of shares of each class of nonvoting stock.

Although the tax code provides for non-recognition treatment if property is transferred "solely" in exchange for stock, this does not mean that the entire exchange will be taxable if the shareholders receive cash or other property in addition to stock. If property other than stock is received, the shareholder will recognize gain to the extent the he or she receives such property. Though I did not make any changes to this paragraph, it is to minimal to accurately explain a transfer under code section 351.

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, he will have a gain of $80,000 because his basis in the stock is the basis of the property originally transferred in exchange for the stock.

In order to eliminate the double taxation burden, 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. 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. A family of up to six generations is considered one shareholder. An S corporation must not be an ineligible corporation, which is defined to include members of an affiliated group, financial institutions, and certain other entities.

An S election for any taxable year must be made on or before the fifteenth day of the third month of the taxable year or at any time in the preceding taxable year. Thus, an election for calendar year 1999 may be made anytime in 1998 or before March 15, 1999. The election is made by filing a properly completed Form 2553 with the Internal Revenue Service. All persons who are shareholders on the day of the election (and in some cases former shareholders) must consent. Once the election is made, it is effective until revoked or terminated.

Corporations are required to file annual income tax returns. The returns are due the fifteenth day of the third month after the close of the taxable year. Extensions to file are available. A C corporation pays tax on its net taxable income (gross income less allowable adjustments and deductions). A controlled group of corporations is subject to the same rates as though the group was one corporation.

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. Foreign laws and international tax treaties must also 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.

Form: Internal Revenue Service Audit

To read and printout a copy of the Form please link below.

Internal Revenue Service Audit

You can download a free copy of Adobe Acrobat Reader here.

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