In my post about large tax increases coming for dividends, there were several replies on our blog regarding how this affects S corporation dividends and other related issues.
I thought I would use this post to give our farmers a quick update on how income is taxed for C corporations and S corporations.
First, a C corporation simply refers in the part of the Internal Revenue Code dealing with corporate taxation (C). Almost all farm corporations are C corporations unless they elect to be taxed as an S corporation (to be discussed below).
A C corporation will each year compute it taxable income and then pay an income tax based upon the bottom line. If the taxable income is less than $50,000 the tax rate is 15%, however, as the income increases over this amount, the tax rates increase substantially and for income between $100,000 and $335,000, the rate is 39% plus whatever the state income tax rate will be.
After this income is computed and the corporate tax paid, the shareholder will be subject to a separate tax when this income is distributed to the shareholder as a dividend. Right now, this rate is 15%, however, starting next year as discussed in the post, the rate will skyrocket to close to 40% or and starting in 2013, the rate may exceed 40% due to the new Medicare surtax on investment income.
Now, if the farmer would like to stop this so-called double tax, they can elect for the corporation to be taxed as an S corporation (again this is the section in the Internal Revenue Code dealing with these types of corporations, that is why it is called an S corporation). This election allows the corporation to pay no corporate tax and have all of the income flow through to the shareholders who then pay the tax at their normal tax rates. This means that when the corporation pays a dividend to the shareholders, there is no additional tax since the tax has already been paid on the income.
Why would a farmer ever want to be a C corporation if there is this double tax? There are many cases where a farmer would want to be a C corporation. For example, assume the farm only earns about $75,000 a year. Under this scenario, the farmer using proper tax planning would most likely not pay any tax at all if they have two or more minor children, whereas, being taxed as an S corporation could result in several thousand dollars of tax (see previous posts on this).
The bottom line is that you need to review your income tax situation both for the current year and for future years and determine which corporation works best for you.