C Corporation

A C corporation is a corporation taxed under Subchapter C of the Internal Revenue Code, which is the default treatment for any corporation that has not made an S election. The Code defines it negatively and in a single line: section 1361(a)(2) provides that "the term 'C corporation' means, with respect to any taxable year, a corporation which is not an S corporation for such year." The corporation computes its own taxable income and pays tax on it at the flat 21 percent rate set by section 11(b).

The label describes tax treatment, not legal form. A business becomes a corporation, or a limited liability company, under a state statute; whether it is a C corporation or an S corporation is a separate federal question decided by whether an election is in effect. An LLC that files Form 8832 to be classified as a corporation, and makes no S election, is a C corporation for tax purposes while remaining an LLC under state law.

Double taxation is a description of two events, not one. The corporation pays 21 percent on its taxable income. A shareholder pays again only when profit is actually distributed as a dividend, or when the shareholder sells stock whose value reflects the retained profit. Nothing taxes the shareholder on the corporation's earnings as they accrue, which is the exact opposite of a pass-through, where the owner is taxed on their share whether or not a dollar is distributed. That difference is why the C corporation is not automatically the worse answer: a business reinvesting everything it earns may be better off paying 21 percent and deferring the second layer indefinitely than paying an owner's marginal rate on income they never receive.

The Code anticipates that argument and puts two limits on it. Section 531 imposes an accumulated earnings tax "equal to 20 percent of the accumulated taxable income" on a corporation described in section 532, which is one "formed or availed of for the purpose of avoiding the income tax with respect to its shareholders ... by permitting earnings and profits to accumulate instead of being divided or distributed." Section 532(c) adds that this applies "without regard to the number of shareholders," so it is not a closely-held-company rule. The escape is the accumulated earnings credit in section 535(c), which shelters earnings "retained for the reasonable needs of the business," subject to a minimum credit measured against $250,000 of accumulated earnings and profits. Section 535(c)(2)(B) halves that floor to $150,000 for a corporation whose principal function is performing services in health, law, engineering, architecture, accounting, actuarial science, the performing arts or consulting, which describes a large share of the closely held corporations that would ever face the tax. Section 541 does the parallel job for a corporation whose income is mostly passive, imposing a personal holding company tax of 20 percent on undistributed personal holding company income. Neither is a common assessment, but both mean "retain it forever" is a strategy the Code already has an answer to.

What only a C corporation can do. Three reasons a business chooses the status deliberately rather than defaulting into it:

• Outside institutional equity. Venture funds and most institutional investors cannot or will not hold pass-through interests, and Subchapter S independently bars most of them: section 1361(b)(1) limits a small business corporation to 100 shareholders, to a single class of stock, and to shareholders who are individuals, estates and certain trusts. A C corporation has none of those constraints and can issue preferred stock.
• Qualified small business stock. The gain exclusion in section 1202 is available only for stock in a domestic C corporation, which is treated on its own page.
• Owner fringe benefits. An owner who is a genuine employee of a C corporation is treated as an employee for fringe-benefit purposes, which is not true of a more-than-2-percent S corporation shareholder or a partner.

Where the second layer actually bites. The painful case is not the growing company that reinvests. It is the profitable service business whose owner needs the money out every year, and the corporation that is eventually sold in an asset sale, where the corporation recognizes gain and pays 21 percent, and the shareholders pay again on the distribution of the proceeds. Converting to S status does not cure that history: a corporation that converts carries a built-in gains tax for a period after the election, which is treated on the S corporation page.

One accounting consequence worth knowing. Section 448(a) bars the cash method of accounting for a C corporation above a gross receipts threshold, which is a real compliance cost that pass-throughs of the same size may avoid. The mechanics of that bar, including its small-business exception, are covered on the cash method and accrual method pages.

The corporation computes taxable income the way any business does, deducting ordinary and necessary expenses including reasonable compensation to its officers, and files Form 1120. It pays 21 percent on what is left. Anything it then distributes as a dividend is taxable to the shareholder, and the corporation gets no deduction for it.

A hypothetical shows both layers. Northline Tooling is a C corporation that earns $500,000 of profit after paying its two owner-employees market-rate salaries. It pays entity-level tax of 21 percent: $500,000 × 21% = $105,000, leaving $395,000 after tax.

• If Northline reinvests all of it in equipment and working capital, the shareholders owe nothing this year. The tax cost of the profit was $105,000, an effective 21 percent, and the second layer is deferred until the money comes out or the shares are sold.
• If Northline distributes all $395,000 as a qualified dividend and the shareholders are in the 15 percent capital gain bracket, they owe $395,000 × 15% = $59,250. Combined tax on the original $500,000 is $105,000 + $59,250 = $164,250, an effective rate of 32.85 percent.

The same $500,000 earned by an S corporation would have been taxed once on the owners' returns, at their own marginal rates, whether or not it was distributed. Which arrangement costs less depends on the owners' rates and on whether the money needs to leave the business, which is the actual question behind the entity choice. These are hypothetical figures using the statutory 21 percent rate; a real comparison also has to account for state tax, employment tax on wages, and the qualified business income deduction, none of which this simplified example includes.

Pros

• A flat 21 percent entity rate that does not rise with profit, and that is below the top individual rate.
• No tax to the owners on undistributed profit, so a reinvesting business is not taxed on money its owners never receive.
• No limit on the number or type of shareholders and no single-class-of-stock rule, which is what makes outside institutional investment possible.
• Eligibility for the section 1202 gain exclusion, which no pass-through offers.
• Owner-employees are treated as employees for fringe-benefit purposes.

Cons

• Profit distributed as a dividend is taxed twice, and the corporation gets no deduction for the dividend.
• An operating loss stays trapped at the entity level as a carryforward rather than flowing to the owners' returns, which is a real cost in early years.
• The qualified business income deduction is not available for C corporation income; it is a deduction for owners of pass-through businesses.
• Accumulating profit to defer the second layer runs into the accumulated earnings tax and, for passive income, the personal holding company tax.
• Section 448(a) generally denies the cash method above a gross receipts threshold, adding accrual accounting cost.
• An asset sale of the business produces both layers at once, and the structure is easier to enter than to leave.