Subchapter C: An Income-driven Tax Status for Corporations
Subchapter C is the default tax status for corporations, and it also applies to LLCs that choose to be taxed as corporations. Companies that use Subchapter C taxation are “double taxed,” meaning they are taxed once at the entity level and that same income is taxed again at the individual level when profits are distributed to the shareholders. Most cooperative corporations choose to be taxed under Subchapter T instead, because the overall tax burden is likely lower.
The principle of double taxation
Under Subchapter C, net income is taxed at the entity level at the corporate tax rate at both the federal and state level. If the corporation pays dividends to its shareholders, the shareholders must also pay income tax on those dividends. This is known as “double taxation” because the corporation cannot deduct dividends as a business expense, so its income is taxed at both the corporate level and again at the individual level, if distributed to shareholders.
In other words, the same money is being taxed twice, once for the owner and once for the company.
Why might a cooperative choose Subchapter C?
It’s fairly unusual for cooperatives to choose the Subchapter C tax election. Subchapter T is more common, because it typically offers more tax benefits. However, Subchapter T may subject members to self-employment tax which is 15.3%. The main reason to choose Subchapter C, then, is to avoid this.
Under Subchapter T, co-ops can already avoid double taxation and decide whether net income will be taxed at the shareholder level (by allocating patronage dividends to its members) or at the corporate level (by allocating it to a collective account). These dividends would be subject to that tax as well as income tax at the individual level. For more information on why that is the case, see this article by a CPA who specializes in cooperative taxation. The instructions to the Form 1040 tell tax payers to report their patronage dividend income on the Schedule C or Schedule C-EZ, which are forms used to report business income, rather than investment income. Income from these schedules is almost always subject to self-employment tax. There is an argument that this income should not be subject to self-employment tax; however, some cooperatives do not want to take the legal risk of not paying. In contrast, it is clear that Subchapter C dividends are treated as ordinary income.
On the whole, few cooperatives elect Subchapter C taxation because the overall tax burden is likely higher for most companies than Subchapter T.
(This tax liability can be minimized through wages or employee bonuses rather than dividends.)
Implications for Large and Small Corporations and Cooperatives
If the company retains most of its net income, it will only be taxed at the corporate level, which could mean a tax savings. Larger corporations have seen a significant tax reduction at the federal level, which is now a flat 21% at the federal level. Previously, the top corporate interest rate was 35%; however, tax rates varied from 15% to 35% depending on the amount of income subject to tax. Small corporations, with taxable income up to $50,000, have seen a tax increase with the tax bill that went into effect in 2018. But for larger corporations with shareholders in upper tax brackets, the marginal rate applicable to the corporation may be lower than the marginal rate which the shareholders would pay.
The main takeaway here is that if a company retains most of its net income, it could potentially be taxed only at the corporate level, resulting in tax savings. Larger corporations have benefited from a federal tax reduction, whereas small corporations with taxable income up to $50,000 have seen a tax increase. Additionally, for larger corporations with shareholders in higher tax brackets, the marginal tax rate applicable to the corporation may be lower than the marginal rate that the shareholders would have to pay. In other words, If a corporation keeps most of its income, it may only be taxed at the corporate level, which can save them money. Recently, larger corporations have benefited from a reduction in federal taxes, while smaller corporations have seen a tax increase. For bigger corporations with shareholders who have high incomes, the tax rate for the corporation might be lower than what the shareholders would pay individually.
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