ABA Family Legal Guide

Forming and Operating a Small Business

Types of Business Organizations

Corporations

How are C Corporations taxed?

Unless your corporation has chosen to be taxed as an S corporation, it's automatically taxed as a C corporation. This means it must pay a tax on its net taxable income, and then the shareholders must pay a second tax on any of the corporation's net earnings that are distributed as taxable dividends.

But in a small corporation, where all the shareholders work in the business, it may be possible to avoid taxation on profits by avoiding the profits! If the owner-employees pay themselves enough (while still satisfying IRS rules that the compensation be "reasonable") there would be no profit, and thus no tax on the business or on dividends.

In such a situation, a C corporation might enjoy some tax advantages over the other forms. The key is that a corporation is a separate taxable person. Shareholders who are employed by a corporation in some capacity can qualify as employees of the company. As a result, they're eligible for special life and medical insurance programs and other fringe benefits. These can result in tax deductions to the company for the cost of these business expenses. These breaks aren't available to sole proprietors, partners, and the members of a limited liability company, who are regarded as self-employed.