How are Businesses Taxed?
An overview of personal and business income taxes.
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How are business entities taxed?
Understanding basic taxation concepts as they apply to each entity type will give you sufficient background to understand the important tax considerations in a transaction by a given business entity. To understand taxation of business entities, it is important to understand personal taxation as well as business taxation.
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What is Individual Income Taxation?
Individuals pay federal and state taxes on a percentage of their adjusted gross income (AGI) in a given tax year. AGI is calculated as an individuals gross income, minus all deductions (either the standard deduction or itemized deductions) and the individuals personal exemption. A persons gross income is comprised of wages or other income, dividends, and investment interest, gains, dividends, rents, royalties, etc. Deductions are numerous categories of expenses that the state and federal government exempts from taxation. A person can either claim individual deductions, known as itemizing deductions or claiming a standard deduction.
- Note: The standard deduction in 2018 is $12,000 for single individuals. This changes for individuals filing jointly or as head of household. Prior to 2018, each taxpayer also had a personal exemption is $4,050. The personal exemption went away in 2018 with the increase of the standard deduction. The state and Federal Governments also allow various credits that subtract directly from the amount of income tax liability.
- Example: Each year I am required to tally all of my earnings from a number of sources. I then subtract all deductions allowed by the state and federal governments. If my individual deductions do not add up to an amount greater than the allowed standard deduction, I will subtract the standard deduction. This amount is my AGI. Calculation of my income tax liability for the year will be based upon this amount.
The income tax rates for wages and other income are tiered. All individuals pay a fixed percentage on the first several thousand dollars of their AGI, a fixed percentage on the next several thousand, etc.
- Note: The 2016 federal tax brackets for single individuals are 10, 12, 22, 24, 32, 35, and 37%. The dollar amount of income that fits in each bracket depends upon whether the individual files as a single taxpayer, married filing separately, head of household, or married filing jointly.
- Example: Assume the rates stated above apply. I am not married and file as a single tax payer. I make $30,000 in a year in wages. I take the standard deduction (and personal exemption if filing prior to 2018). Assuming it is 2018 income, my AGI is $18,000. The first $9,525 will be taxed at 10%. The remaining $8,475 will be taxed at a 12% rate. These two amounts are combined, and my total federal tax liability for the year is $1967.34. Note that this overly simplified example assumes that I have no additional deductions for state taxes, Medicare or Social Security payments that would reduce my taxable income amount.
Individuals also pay taxes on gains. Gains consist of value received and recognized when an asset is sold for a higher value than the owners basis in the property. Long-term capital gains (gains on certain assets held longer than 12 months) and dividends are taxed at different rates than other forms of gross income. Short-term capital gains are taxed at ordinary income rates. The tax rate for long-term capital gains and qualified dividends may also be tiered based upon income. While they are included in gross income, qualified dividends and long-term capital gains are subject to different tax rates from other sources of income.
- Note: In 2016, long-term capital gains and qualified dividends are taxed at 0, 15, and 20%, based upon income levels. The 0% rate applies to individuals with at total AGI of up to $38,600. The 15% rate applies to individuals with at total AGI of up to $425,800. The 20% rate applies to individuals with total AGI above $425,800.
- Example: I purchase a single share of stock in ABC Corp for $5. Six months later I sell the stock for $10. I have gains of $5. Because I held the stock for 6 months, the gains are treated like wages and taxed at that rate. If I had held the stock for longer than 12 months, the applicable tax rate would have been the applicable long-term rate.
What is Business Income Taxation?
Business taxation is more complicated than individual taxation. Business entities are either not taxed at all, or they are taxed at a corporate rate. If a business entity is classified as a pass-through tax entity, it does not pay income taxes. Rather, the business owners pay taxes on any business profits. Restated, the profits or losses from the business activity pass through to the individual and are reported on her individual income tax form. Businesses that pay taxes, such as businesses taxed under Subsection C of the Internal Revenue Code ("C-Corps), are taxed at the corporate rate. Like the individual tax system, the corporate tax rate is tiered.
- Note: The applicable tax rate for C-Corp is a flat rate of 21%. Prior to 2018, the applicable corporate tax rates are 10% ($0-50,000), 25% ($50,000 - 75,000), 34% ($75,001 -100,000), 39% ($100,001 - 335,000), 34% ($335,001 - 10,000,000), 35% ($10,000,001 - $15,000,000) , 38% ($15,000,001 - 18,333,333), and 35% ($18,333,333 & up).
- Example: I form an LLC. I can elect with the IRS for the business to either be taxed as a partnership or a corporation. If I elect to be taxed as a partnership, the LLC will be taxed as a flow-through tax entity. The business entity will not pay income taxes; rather, all profits or losses will flow directly through to me and I will report the income on my personal income tax return and pay the applicable taxes.
Business entities taxed under Subsection C of the Internal Revenue Code (IRC) pay income taxes on profits. Corporations taxed in this manner are known as C-corporations. These taxes are treated as an expense to the corporation. They are deducted, along with other expenses, to determine whether the corporation is profitable or has profits at the end of the tax year. Any distribution of corporate profits to shareholders is a dividend and is taxed to the shareholder at the applicable dividend rate. The shareholder reports those dividends on her personal income tax return.
- Note: A business taxed as a C-corporation is not required to distribute profits. These are known as retained earnings. A shareholder does not pay taxes on the income until it is distributed. In a pass-through entity, the business entity does not pay taxes. As such, owners of the business must pay taxes on the profits whether the profits are distributed or no.
- Example: I form a corporation and elect to be taxed under Subsection C of the IRC. The corporation brings in $12,000 and has expenses of $2,000 in the tax year. The corporation has taxable income of $10,000. The applicable tax rate is 21% on this amount, equaling $2,100. So, after taxes, the corporation has profits of $8,900. If the corporation decides to pay a dividend to me as the sole shareholder, I will report the dividend payment on my personal income tax return and pay taxes on the dividend amount. If, however, the corporation decides to retain all of the earnings and not pay a dividend, I will not be taxed on the profits. In contrast, in a flow-through tax entity, the business entity itself would not pay taxes. Rather, all $10,000 of profit (taxable income) would automatically flow through to me. I would report the entire amount on my personal income tax return and pay the applicable taxes.
Discussion: Can you think of a situation where an individual would be subject to a personal income taxes on a portion of the money received from a corporation and subject to dividend taxes on other amounts of money received? Please explain.
Practice Question: I am an employee and shareholder of ABC Corp. I draw a salary of $30,000 from the corporation. At the end of the year the corporation has a profit of $100,000. It decides to pay dividends to shareholders. Based upon the shares I own, I receive dividends of $1,000. In this scenario, what taxable income must be reported to the Federal Government?
- I must pay federal income taxes on the $30K salary. This will be subject to income taxation and FICA taxes. I will also have to pay taxes on the $1K dividends. Because the corporation is taxed under subsection C of the Internal Revenue Code, it will be taxed at a special dividend rate.