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Taxing the Corporate Form

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Earnings and Profits:
Companies, like individuals, make money via the businesses that they operate. While individuals would treat such money as wage income from their jobs, companies treat such income as earnings and profits, and that is the income on which they must pay taxes. The exact computation of the earnings and profits ("E&P") number is quite complex, but for our purposes, we will treat this number as the gross income that a company earns over the course of a year.

Taxable Year:
While individuals pay tax based on the income earned over the course of a calendar year (January 1 to December 31), corporations and many other businesses do not (and, in many cases, are not allowed) to calculate income on that basis. Taxable years that start on July 1 or on certain dates in September are often used by companies. Do not assume that a corporation's taxable year is the same as the calendar year.

Introduction to Corporate Taxation

Just about everyone is familiar with the chaos associated with April 15th every year. As tax season approaches, individuals enter a panic mode to ensure that all of their W-2s are in and that they have totaled up all of their deductions, filled out all of the forms that the IRS requires and prepared their tax returns in a presentable form. What most taxpayers forget is that companies, from the corner grocer to Johnson & Johnson, are also required to file their taxes, though not necessarily on April 15th. How would you like to be responsible for filing GM’s tax return?

Before you break into a sweat considering the complexity of such a task, consider the fact that GM, like every other major company, has a phalanx of lawyers, accountants and other staff members responsible for navigating the tax code and addressing the company’s myriad of business interests. That is a good thing, as the tax code with regard to corporations is an incredibly complex and nuanced mechanism, of which it can require years of study to develop even the most cursory understanding.

In the end, the goal of this subchapter is only to introduce you to the most basic elements of corporate taxation. Keep in mind, however, when you are working with a corporation, that the decisions that it is making that do not correspond to your experience or make sense to you may be made solely on the basis of the tax benefits that they incur.

A Corporate Tax Primer

One question that still haunts tax practitioners to this day is how to tax corporations at all. This is because of what is described as the “double taxed” nature of the U.S. corporate tax regime. First, the company is itself taxed on funds that it receives from transactions. That is to say that the company pays taxes on its earnings just like an individual pays taxes on his or her wages. The problem is that after taxes are paid, the remaining income that goes into the company must eventually come back out again. In other words, over time, as the company pays dividends, sells assets or ultimately liquidates, the value of the company is paid out to its shareholders. The problem of double taxation is that the government now takes a second bite at the apple, taxing these dividends and distributions as they enter the hands of the shareholder. See 26 USCS § 301

EXAMPLE: Sally, who owns a manufacturing company, sells her handbags to a retailer at a profit. Subsequently, she chooses to make a distribution to her shareholders of the full amount of the profit on the handbag sale. Sally will have been taxed on the profits from the sale of the handbags as a corporation. Then, after the distribution, her shareholders will be taxed on the amount of the distribution. This is the effect of the double nature of the corporate tax.

Ultimately, this system has been called into question by many tax experts. The fact is, however, that despite the occasional test to the system, it has remained this way since the U.S. income tax was first instituted in 1913. For this reason, companies often plan years ahead to develop tax strategies that confer the most tax benefits to the corporation and, in turn, to its shareholders.

Taxation of Dividends and Distributions

Perhaps the most important aspect of corporate taxation that is unfamiliar to the average person is the nature of taxation on corporate dividends and distributions made to investors. As a person who may have clients who make investments over time, the legal professional should be concerned with the payment of taxes related to distributions made by a company. If you do not pay attention to this issue, there is only so much that the corporation can do for you, and you may face a tax bill higher than what you otherwise might be required to pay. 

EXAMPLE: Sally, in the example above, may have been able to make a decision that would have been more effective for her shareholders. Unless her shareholders were clamoring for a distribution, her optimal strategy may have been to retain the profits in her handbag company, thereby increasing the value of the firm and delaying the tax burden on her shareholders.

Basically, almost every instance in which a company gives funds to its shareholders – and in many instances, if the company distributes property to shareholders in lieu of funds – that payout, known as a distribution (or dividend) is a taxable event. See 26 USCS §§ 301-307. 

The way that the government views such a transaction is that you, as an investor, have sold a piece of property in the same way that you might sell your car, and such a transaction requires the reporting of income. In the tax parlance, this is known as a “return to capital” and will result in an increase in your tax bill. See Fulman v. United States, 434 U.S. 528 (1977). In theory, there is something that you, as an individual, can do to control such a situation, by voting to change corporate policy. Still, such an action by an individual shareholder of a large corporation is unlikely to have a substantial effect. Instead, you should plan ahead to consider just how such a distribution might affect your ownership interest in the company and how it will impact the rest of any investment portfolio that you may have.

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