C Corporation A C corporation is a separate legal entity that pays its own taxes, distinct from its owners (shareholders). How C Corporations Are Taxed C corporations face "double taxation" : 1. First tax: The corporation pays tax on its profits at the federal corporate rate of 21 percent and Minnesota's corporate rate of 9.8 percent . 2. Second tax : When the corporation distributes profits to shareholders as dividends, shareholders pay individual income tax on those dividends (rates range from 10 to 37 percent federally, plus Minnesota individual rates). Important: The corporation cannot deduct dividends it pays to shareholders, so the same income is effectively taxed twice. Tax Planning Options for C Corporations 1. Retain earnings instead of paying dividends C corporations can keep profits in the business rather than distributing them to shareholders, avoiding the second layer of tax. However, the IRS limits how much you can accumulate—excessive retained earnings may trigger an accumulated earnings tax . 2. Pay reasonable salaries to owner-employees Owner-employees can receive salaries, which are deductible by the corporation (reducing corporate taxable income). However, salaries must be reasonable for the work performed. The IRS may reclassify excessive salaries as dividends, which are not deductible. What Happens to Income Characteristics? In a C corporation, the character of income items (like capital gains or charitable contributions) does not pass through to shareholders. Everything becomes ordinary dividend income when distributed. Similarly, corporate losses do not pass through to shareholders—they stay with the corporation. S Corporation An S corporation is a special type of corporation that elects to be taxed as a pass-through entity , similar to a partnership. How S Corporations Are Taxed S corporations do not pay federal or Minnesota corporate income tax (with limited exceptions). Instead, income, deductions, and credits "flow through" to shareholders, who report them on their personal tax returns.
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