The Corporation as a Taxable Entity

• Pages: 73-102
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

73

Chapter 3

THE CORPORATION AS A

TAXABLE ENTITY

3.01 Corporate Tax Rates and Base

As one of its signature changes, the 2017 tax act amended

§ 11(b), imposing a flat 21-percent tax on the taxable income of a C

corporation. Before the amendment, the corporate tax was

progressive for some, regressive for others, and flat for most.

1

The act

substantially reduced the tax rate for large, profitable corporations

and affiliated groups filing consolidated returns, dropping the stated

rate from 35 to 21 percent, a 40 -percent reduction. However, some

smaller or less profitable corporations or groups, formerly taxed at

just a 15- percent rate, will suffer a 40-percent tax rate increase.

Nevertheless, the tax reduction will overwhelm any tax increase,

because the taxable income for the large profitable corporations will

dwarf the taxable income of the smaller or less profitable

corporations.

With some exceptions, a corporation computes its gross income

and deductions m uch like an individual. However, unlike an

individual, a corporation generally must use the accrual method of

accounting.

2

As one exception, a corporation may use the cash

method if it had average annual gross receipts of no greater than $25

million (as adjusted for inflation) over the preceding three years.

3

The cash method can also be used by a qualified service

corporation,

4

which is a corporation that meets a function and an

ownership test.

5

Under the function test, substantially all of the

activities of the corporation must involve the performance of services

1

Before that ame ndment § 11 had the following graduated rate schedule: A

15-percent rate was imposed on the first $50,000 of taxable income, a 25-percent rate

on the next $25,000 of taxable income, a 34 -percent rate on the next $9,925,000 of

taxable income, and a 35-percent rate on any remaining taxable income. The benefit

of graduation was eliminated with two add-on taxes, however. A 5-percent add-on tax

was imposed on taxable income between $100,000 and $335,000, eliminating the

benefit of the lowest two graduated rates, while a 3-percent add-on tax was imposed

on taxable income between $15,000,000 and $18,333,333, eliminating the benefit of

the 34-percent rate.

2

§ 448(a)(1).

3

See Rev. Proc. 2024–40, 2024–45 I.R.B. 1100 (§ 3.31) (for ta xable years

beginning in 2025 increasing the threshold to $31 million). Under the law in effect

before the 2017 act, the average annual gross receipts could not exceed $5 million.

4

§ 448(b)(2). See also id. at (b)(1) (providing that a farming business may use

the cash method).

5

§ 448(d)(2).

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THE CORPORATION AS A TAXABLE ENTITY

Ch. 3

in the fields of health, law, engineering, architecture, accounting,

actuarial science, performing arts or consulting.

6

Under the

ownership test, substantially all of the stock (by value) of the

corporation must be held directly or indirectly by employees

performing those services, by retired employees who performed those

services in the past, by their estates, or by persons who hold stock in

the corporation by reason of the death of such an employee or retired

employee within the past two years.

The flat 21-percent income tax rate structure may lure a high-

income individual to use the corporate form to shelter income from

the top individual rates. This incentive is enhanced by the

preferential rates typically imposed on the individual’s sale of stock

or her receipt of dividends. Currently for individuals, the top tax rate

applicable to most long-term capital gains and qualified dividends is

20 percent, while the top rate for ordinary income is 37 percent.

7

For corporations, however, capital gains, whether long- or short-

term, are taxed at the same rate as ordinary income.

8

Capital losses

of corporations are also treated differently than those of individual

taxpayers. A corporation can deduct capital losses only to the extent

of capital gains.

9

Further, unlike individuals who can carry forward

capital losses indefinitely, corporations generally can only carry

losses back three years (perhaps resulting in a tax refund) and

forward five years, if necessary. A loss unused in the current year is

first carried back and then carried forward chronologically until the

entire loss is used to offset income or the carryforward period expires.

Because corporate distributions historically were taxed to the

recipient shareholders at ordinary income rates, while gains from the

disposition of stock were taxed as capital gain, the capital gains

preference historically has encouraged shareholders to eschew

6

Note that it is not always apparent whether a corporation meets this test.

For example, a corporation that engages in financial planning is a qualified pers onal

services corporation if the corporation is paid for its advice regardless of outcome. On

the other hand, if payment is based on trade orders executed, the corporati on is not a

qualified personal service corporation. Regs. § 1.448–1T(e)(4)(iv).

7

This incentive is undercut in several ways. First, an individual may be

entitled to a deduction up to 20% of her business income. See § 199A. Second, higher-

income taxpayers may be subject to an additional 3.8% tax on net investment income.

See § 1411(a). Finally, in certain cases, the corporation may be subject to an additional

penalty tax if it fails to distribute dividends. See Chapter 12 (discussing the

accumulated earnings and personal holding company taxes).

8

Note that § 1201 provides for an alternative tax on net capital gains in lieu

of the § 11 tax if the § 1201 tax is less. The § 1201 tax is the sum of (1) the § 11 tax on

the corporation’s taxable income minus net capital gains and (2) 35% of the net capital

gains. Section § 1201 takes ef fect if the tax rate under § 11, disr egarding the 3% and

5% surtaxes, exceeds 35%. Because that rate does not exceed 35%, the alternate tax

on net capital gains does not apply, and those gains are taxed at § 11 rates.

9

§ 1211(a). Other taxpayers can use capital losses to offset up to $3,000 of

ordinary income. § 1211(b).