How Texas corporations are taxed: an overview
If you are considering incorporating your business, getting some advice from a Conroe Texas business attorney about the tax consequences is probably a good idea. Corporate taxation is an extremely complex topic, but it is possible to get a grasp on a few of the key points in a brief article.
How a corporation is taxed depends on whether it is a “C” corporation or an “S” corporation.
C corporations file a corporate income tax return (Form 1120) and are taxed on their profits at corporate tax rates.
Shareholder salaries. If shareholders are employed by the corporation, they are taxed on their salaries and bonuses, which the corporation can deduct as a business expense. Sometimes a small business organized as a corporation will not have any profits to pay tax on because salaries and bonuses paid to shareholder-employees eliminate them.
Dividends. If the corporation pays shareholders a dividend, it is subject to a double tax, once at the corporate rate (because dividends, unlike salaries and bonuses are not deductible) and again at the tax rates applicable to the shareholders who receive them. The double-taxation can be avoided in some cases by characterizing the payments as salary or bonus; however the amount must be reasonable compensation for the shareholder's services.
Income splitting. Business owners may want to retain some profits in the corporation rather than distributing them all to shareholders. Retained profits can be used to expand the business or to provide a cushion against a future business downturn. Retaining profits may provide the owners with some tax savings because initial corporate income tax rates may be lower than the marginal income tax rates the owners would pay on the same amount of income.
In contrast, sole proprietors, partners, and LLC members must pay taxes on all business profits at their individual income tax rates, whether they take the profits out of the business or not.
Fringe benefits. C corporations, like other business entities, can deduct the cost of fringe benefits provided to employees, including the business's owners. However these benefits are tax-free to the shareholder-employees of a C corporation. Owners of other types of business who receive fringe benefits will ordinarily be taxed on their value.
If a corporation meets certain requirements, its shareholders can elect S corporation status. S corporations are not taxed at the corporate level. Like partnerships, their profits (and losses) are passed through to the shareholders and taxed at their income tax rates. An S corporation with more than one shareholder must file an informational tax return, like a partnership or LLC, to report each shareholder's share of the corporation's profits or losses.
To qualify for S corporation status, a corporation must:
- Be a domestic corporation.
- Have only certain types of shareholders, which include individuals, but not partnerships or corporations.
- Have no more than 100 shareholders.
- Have one class of stock.
- Not be an ineligible type of corporation, such as a financial institution, or insurance company.
Usually, a start-up company will benefit from choosing to be an S corporation because the single level of taxes will result in a smaller total bill. Also, if the corporation operates at a loss in early years, shareholders may be able to deduct their share of the loss against other income, subject to some limitations. For example, a shareholder cannot deduct more than he has invested (at risk) in the corporation. But sometimes the benefits of income-splitting and favorable fringe benefit taxation will tip the scale in favor of a C corporation.
Get help from an experienced Texas business attorney
For help making the decision of whether to incorporate and whether to make an S election, phone us 936-337-4681 or 979-703-7014 to schedule a consultation. The Conroe, Texas business attorneys at the Peterson Law Group look forward to learning how we can help you grow your business.