CPA REG: C Corporation Tax Rules and Concepts

C Corporation Taxation for the CPA REG Exam

C corporations are taxed as separate entities under Subchapter C of the IRC. Unlike pass-through entities, C corporations pay their own income tax and shareholders are taxed again when distributions are made, creating the double taxation characteristic of corporate taxation. The REG exam tests corporate formation, taxable income computation, special deductions, penalty taxes, and distributions.

Corporate Tax Rate

Under the TCJA, C corporations are subject to a flat 21% federal income tax rate. The graduated rate structure that existed prior to 2018 was eliminated. Corporate taxable income is computed similarly to individual taxable income, with some significant differences. Corporations do not receive a standard deduction, cannot deduct personal exemptions, and have different rules for capital losses, charitable contributions, and net operating losses.

Corporate Formation (IRC Section 351)

Under Section 351, no gain or loss is recognized when property is transferred to a corporation solely in exchange for stock, provided the transferors are in control of the corporation immediately after the transfer. Control means owning at least 80% of the total combined voting power and 80% of each class of nonvoting stock. If boot (cash or other property) is received in addition to stock, gain is recognized to the extent of the boot but cannot exceed the realized gain. Loss is never recognized in a Section 351 transaction, even if boot is received.

Services do not count as property for Section 351 purposes. A person who contributes only services does not count toward the 80% control requirement. However, if a person contributes both property and services, they count as a transferor and are included in the control group, though the stock received for services is taxable as compensation.

Dividends Received Deduction (DRD)

The DRD under IRC Section 243 mitigates triple taxation when one corporation receives dividends from another domestic corporation. The deduction percentage depends on the ownership level: 50% DRD for ownership less than 20%, 65% DRD for ownership of 20% or more but less than 80%, and 100% DRD for ownership of 80% or more (affiliated group members). The 50% and 65% DRDs are limited to 50% and 65% of taxable income, respectively, unless applying the limitation would create or increase a net operating loss.

Corporate Capital Losses

Unlike individuals, corporations cannot deduct capital losses against ordinary income. Corporate capital losses can only offset capital gains. Net capital losses may be carried back three years and forward five years, and all carrybacks and carryovers are treated as short-term capital losses. This is a frequently tested distinction from individual capital loss rules.

Charitable Contribution Limitation

Corporate charitable contributions are limited to 25% of taxable income, computed before the charitable contribution deduction, the DRD, any net operating loss carryback, and any capital loss carryback. Excess contributions may be carried forward five years. Corporations that donate inventory to qualifying organizations may claim an enhanced deduction equal to the lesser of basis plus half the appreciation or twice the basis.

Net Operating Losses

Under the TCJA, corporate NOLs arising after 2017 may be carried forward indefinitely but cannot be carried back (with limited exceptions for farming losses). The NOL deduction is limited to 80% of taxable income (before the NOL deduction) for losses arising after 2017. Pre-2018 NOLs retain their pre-TCJA character and may be carried back two years and forward 20 years without the 80% limitation.

Accumulated Earnings Tax (IRC Section 531)

The accumulated earnings tax is a penalty tax imposed on corporations that accumulate earnings beyond the reasonable needs of the business for the purpose of avoiding shareholder-level tax on dividends. The tax rate is 20% of accumulated taxable income. Corporations are entitled to an accumulated earnings credit of $250,000 ($150,000 for personal service corporations), reduced by accumulated E&P at the end of the prior year. The accumulated earnings tax does not apply to S corporations, tax-exempt organizations, or personal holding companies.

Personal Holding Company Tax (IRC Section 541)

The personal holding company (PHC) tax is a 20% penalty tax imposed on undistributed PHC income. A corporation is a PHC if it meets two tests: (1) the stock ownership test, meaning more than 50% of the stock is owned by five or fewer individuals at any time during the last half of the tax year (applying constructive ownership rules), and (2) the income test, meaning 60% or more of adjusted ordinary gross income is PHC income (dividends, interest, rents, royalties, and certain personal service income). The PHC tax is self-assessed and can be avoided by paying sufficient dividends, including consent dividends.

Corporate Distributions

Distributions from a C corporation are treated as dividends to the extent of the corporation's current and accumulated earnings and profits (E&P). Distributions exceeding E&P are treated as a return of capital, reducing the shareholder's stock basis. Distributions exceeding both E&P and basis are treated as capital gain. Current E&P is allocated pro rata to all distributions made during the year.

Exam Tips

• Master the Section 351 control test (80% voting and nonvoting)
• Know the DRD percentages and the taxable income limitation
• Corporate capital losses only offset capital gains (3-year carryback, 5-year carryforward)
• Charitable contributions are limited to 25% of adjusted taxable income
• The accumulated earnings tax and PHC tax serve different purposes and have different requirements
• NOLs after 2017 are limited to 80% of taxable income with no carryback