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CORPORATE TAXATION

A corporation is a separate legal entity that must pay income and other taxes separate from its shareholders.  As a result, net income is potentially subject to double income taxation.  Net income is taxed at the corporate level on an annual basis and taxed again at the shareholder level when corporate profits are distributed to shareholders in the form of dividends.  Certain smaller domestic corporations can elect to pass the net income directly to shareholders and thus avoid double taxation by making what is referred to as an "S" election. A corporation that has not made an "S" election is referred to as a "C" corporation.

Generally, an entity becomes a corporation by filing articles of incorporation with the appropriate state agency governing business corporations.

Upon incorporation, shareholders transfer cash or other property to a corporation in exchange for stock.  The federal tax code reflects a long-standing policy that the incorporation of a business should generally be tax-free to both the shareholders and the corporation.  At the shareholder level, no gain or loss is recognized when property is transferred to a corporation solely in exchange for stock in such corporation if the transferors are in “control” of the corporation immediately following the exchange.  Property is construed broadly to include cash, tangible property, accounts receivable, licenses, and industrial know-how.  However, the term property does not include services.  A shareholder who provides services in exchange for stock will be taxed on the value of the services.  Control means direct ownership of stock possessing at least 80% of the total combined voting power of all classes of stock and at least 80% of the total number of shares of each class of nonvoting stock.

Although the federal tax code provides for non-recognition treatment if property is transferred solely in exchange for stock, this does not mean that the entire exchange will be taxable if the shareholders receive cash or other property in addition to stock.  If property other than stock is received, the shareholder will recognize a gain to the extent that he or she receives such property.

When a shareholder transfers property to a corporation in exchange for stock, the stock will have a cost or basis equal to the cost of the property transferred to the corporation.

Example: If a shareholder transfers property with a basis or cost of $20,000 and a value of $50,000 in exchange for $50,000 worth of stock, the basis of the stock will be $20,000. If the shareholder later sells his stock for $100,000, he will have a gain of $80,000 because his basis in the stock is the basis of the property originally transferred in exchange for the stock.

In order to eliminate the double taxation burden, many eligible corporations will elect S-corporation status to eliminate the corporate tax. To qualify for S-corporation status, the corporation must be a small business corporation for which a Subchapter S election is in effect.

Under current tax law, a small business corporation is a domestic corporation with only one class of stock and no more than 100 shareholders.  Each shareholder must be an individual (other than a nonresident alien), an estate, or an eligible trust.  An S-corporation must not include an ineligible corporation including members of an affiliated group, financial institutions, and certain other entities.  For purposes of the 100-shareholder limit, a husband and wife (and their respective estates) are treated as a single shareholder regardless of whether they hold the stock jointly or separately.  Other joint owners are considered separate shareholders for purposes of the 100-shareholder limit.

Corporations are required to file annual income tax returns.  The returns are due the fifteenth day of the third month after the close of the taxable year.  Extensions to file are available. A C-corporation pays tax on its net taxable income (gross income less allowable adjustments and deductions).  Generally, an S-corporation's taxable income is passed through to its shareholders, who are then taxed on the income.

A complex set of tax rules also covers corporate reorganizations, distributions, redemptions, dividends, acquisitions, and liquidations.  State and local tax laws must also be considered when conducting a corporate business.  For example, businesses operating within the City of Philadelphia must file additional tax returns – such as the Business Privilege Tax and Net Profits Tax, among others.  An experienced tax attorney can help a corporate taxpayer, as well as shareholders, navigate this complex area of the law.

Please contact us for further information.

Powell Trachtman Logan Carrle & Lombardo, P.C.
610-354-9700
www.powelltrachtman.com