C Corporation
A C corporation is a separate legal and taxable entity. For REG, it is the classic corporate tax model: the corporation pays tax on its income, and shareholders may be taxed again when profits are distributed.
Core legal and tax profile
- Owners: Shareholders.
- Liability: Shareholders generally have limited liability.
- Federal return: Form 1120.
- Tax character: Entity-level taxation with possible second-level shareholder taxation.
Formation and capital structure
Section 351 formation
When one or more persons transfer property to a corporation in exchange for stock and are in control immediately after the exchange, the transfer is generally tax free under Section 351.
Basis rules
- Shareholder basis in stock generally starts with the basis of property transferred, adjusted for boot and other items.
- The corporation generally takes a carryover basis in property received.
Capital structure
Corporations can issue different classes of stock and debt, which makes them useful when a business needs outside capital.
Taxation of operations
Corporate taxable income computation
The corporation computes taxable income separately and pays tax at corporate rates. The basic formula mirrors individual income computation but uses corporate-specific rules:
| Step | Description |
|---|---|
| Gross income | Revenue from sales, services, dividends, interest, rents, royalties, and other sources |
| Less: Cost of goods sold | Direct costs associated with producing revenue |
| Gross profit | |
| Less: Ordinary deductions | Compensation, rent, depreciation, repairs, bad debts, etc. |
| Less: Special deductions | Dividends-received deduction (DRD), NOL deduction |
| Taxable income | The amount subject to the corporate tax rate |
:::info Accounting Method — Accrual Requirement
C corporations with average annual gross receipts exceeding $31 million (for tax years beginning in 2025) over the prior three-year period must use the accrual method of accounting. Smaller corporations may use either the cash or accrual method. The threshold is adjusted annually for inflation.
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Compensation deductions
Compensation paid to employees is generally deductible if it is reasonable in amount and paid for services actually rendered.
Key limitations:
- $1 million cap on covered employees: Under Section 162(m), a publicly traded C corporation cannot deduct compensation in excess of $1 million per year for its top five highest-compensated executives (CEO, CFO, and three others). This limit applies to salary, bonuses, commissions, and nearly all other forms of remuneration.
- Accrual-basis bonus timing: An accrual-basis corporation may deduct a bonus in the year it is accrued only if the bonus is paid within 2½ months after the close of the tax year. If Bear Co. accrues a $50,000 bonus for its VP on December 31, 2025, it must pay the bonus by March 15, 2026 to deduct it in 2025.
- Related-party payments: Compensation owed to a related party (e.g., a controlling shareholder) by an accrual-basis corporation is not deductible until the year the related party includes it in income — effectively forcing cash-basis treatment for the deduction.
:::caution Compensation vs. Dividends
The IRS closely scrutinizes shareholder-employee compensation. If compensation is deemed unreasonably high, the excess is recharacterized as a nondeductible dividend. Conversely, if a corporation pays no salary and distributes all profits, the IRS may recharacterize distributions as compensation subject to payroll taxes.
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Bad debts
For tax purposes, C corporations must use the direct write-off method — a deduction is allowed only when a specific receivable becomes wholly or partially worthless.
| Method | Tax | GAAP |
|---|---|---|
| Direct write-off | ✅ Required | ❌ Not acceptable |
| Allowance method | ❌ Not allowed | ✅ Required |
This difference is one of the most common book-to-tax adjustments on the exam.
Example: Gies Co. has $200,000 in accounts receivable at year end. Under GAAP, Gies estimates $12,000 of allowance for doubtful accounts. For tax, Gies can only deduct the specific receivable of $3,500 from Acme Corp that was determined to be uncollectible during the year.
Business interest expense limitation
Under Section 163(j), the deduction for business interest expense is limited to:
- ATI is roughly taxable income before interest, NOLs, and depreciation/amortization adjustments.
- Disallowed interest carries forward indefinitely.
- Small businesses with average annual gross receipts of $31 million or less (2025 threshold) are exempt from this limitation.
Example: Kingfisher Industries has $500,000 of business interest expense, $20,000 of business interest income, and ATI of $1,200,000. The deduction limit is $20,000 + (30% × $1,200,000) = $380,000. The remaining $120,000 is carried forward.
Charitable contribution limits
A C corporation may deduct charitable contributions up to 10% of taxable income computed before the charitable deduction, the DRD, NOL carryback, and capital loss carryback.
| Rule | Detail |
|---|---|
| Limitation | 10% of modified taxable income |
| Carryforward | 5 years (on a FIFO basis) |
| Carryback | Not allowed |
| Accrual-basis timing | Board may authorize in current year; payment must occur by 15th day of 4th month of next year |
Example: MAS Inc. has taxable income of $800,000 before charitable contributions and DRD. The maximum deduction is 10% × $800,000 = $80,000. If MAS donated $95,000, only $80,000 is deducted currently; the $15,000 excess carries forward for up to five years.
:::tip Accrual-Basis Timing Rule
An accrual-basis C corporation can elect to deduct a charitable contribution in the year the board of directors authorizes the donation, as long as payment is made by the 15th day of the 4th month following the close of the tax year (e.g., April 15 for a calendar-year corporation).
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Business casualty losses
A C corporation can deduct casualty and theft losses related to business property. Unlike individuals, corporations are not subject to the $100 floor or the 10%-of-AGI threshold. Business casualty losses are deductible as ordinary losses.
If insurance proceeds exceed the adjusted basis of the destroyed property, the corporation recognizes a gain but may defer it under Section 1033 (involuntary conversion) if replacement property is acquired within the required period.
Organizational expenditures and start-up costs
A corporation may immediately expense up to $5,000 of organizational expenditures in the year the corporation begins business, with the remainder amortized over 180 months (15 years).
The $5,000 immediate deduction is reduced dollar-for-dollar when total organizational expenditures exceed $50,000.
| Cost Type | Examples | Immediate Deduction | Amortization |
|---|---|---|---|
| Organizational | Legal fees for charter, state filing fees, temporary directors' fees | Up to $5,000 | 180 months |
| Start-up costs | Market surveys, advertising before opening, training employees | Up to $5,000 | 180 months |
Costs of issuing stock (e.g., commissions, printing stock certificates) are not organizational expenditures. They reduce paid-in capital and are never deductible.
Example: Illini Entertainment incorporates and incurs $4,200 in organizational expenditures and $48,000 in start-up costs. In year one, it deducts $4,200 of organizational expenditures immediately (under the $5,000 limit). For start-up costs, it deducts $5,000 immediately and amortizes the remaining $43,000 over 180 months.
Capital gains and losses
C corporations follow unique capital gain and loss rules:
| Rule | C Corporation Treatment |
|---|---|
| Capital gains rate | Taxed at ordinary corporate rates (no preferential rate) |
| Net capital loss deduction | Cannot offset ordinary income (no $3,000 deduction) |
| Capital loss carryback | 3 years |
| Capital loss carryforward | 5 years |
| Character on carryback/forward | Always carried as short-term capital loss |
Example: Bear Co. has $600,000 of ordinary income and a $45,000 net capital loss in 2025. Bear Co. cannot deduct any of the capital loss against ordinary income. It must carry the loss back 3 years or forward up to 5 years to offset capital gains in those years.
Unlike individuals, C corporations receive no preferential tax rate on long-term capital gains — all capital gains are taxed at the flat 21% corporate rate.
Inventory valuation methods
C corporations with inventory must account for it using an acceptable method:
- FIFO (First-In, First-Out)
- LIFO (Last-In, First-Out) — if used for tax, must also be used for financial reporting (LIFO conformity rule)
- Weighted average cost
- Specific identification
Inventory must be valued at the lower of cost or market (LCM) under FIFO, or simply at cost under LIFO.
Dividends-Received Deduction (DRD)
When a C corporation receives dividends from another domestic C corporation, it may claim a dividends-received deduction to mitigate triple taxation. The percentage depends on the ownership level:
| Ownership Percentage | DRD Percentage |
|---|---|
| Less than 20% | 50% |
| 20% to less than 80% | 65% |
| 80% or more (affiliated group) | 100% |
Taxable income limitation: The 50% and 65% DRD cannot exceed the same percentage of taxable income computed without the DRD, NOL deduction, and capital loss carryback. However, this limitation does not apply if taking the full DRD creates or increases a net operating loss.
Example — DRD computation:
Gies Co. owns 25% of MAS Inc. stock and receives $100,000 in dividends. Gies Co.'s taxable income before the DRD is $140,000.
| Step | Amount |
|---|---|
| Dividend income received | $100,000 |
| DRD percentage (20%–80% ownership) | 65% |
| Tentative DRD | $65,000 |
| Taxable income limitation: 65% × $140,000 | $91,000 |
| DRD allowed (lesser of tentative or TI limit) | $65,000 |
Since $65,000 < $91,000, the full $65,000 DRD is allowed.
:::info NOL Exception
If applying the full DRD would create or increase an NOL, the taxable income limitation is disregarded and the corporation takes the full DRD. This exception is commonly tested.
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Book-to-tax differences
Because GAAP and tax rules differ, corporations must reconcile book income (per financial statements) to taxable income. Differences fall into two categories:
Temporary differences
These reverse over time and create deferred tax assets or deferred tax liabilities.
| Item | Book Treatment | Tax Treatment |
|---|---|---|
| Depreciation | Straight-line (typically) | MACRS (accelerated) |
| Bad debts | Allowance method | Direct write-off |
| Prepaid income | Deferred on books | Often taxable when received |
| Warranty expense | Accrued when estimated | Deductible when paid |
| Installment sales | Full gain at sale | Gain as payments received |
Permanent differences
These never reverse and create no deferred tax effect.
| Item | Explanation |
|---|---|
| Tax-exempt municipal bond interest | Included in book income, excluded from taxable income |
| Federal income tax expense | Deducted on books, never deductible for tax |
| Life insurance premiums (corp is beneficiary) | Deducted on books, not deductible for tax |
| Life insurance proceeds | Not taxable, but included in book income |
| Meals (50% limit) | Full deduction on books, only 50% for tax |
| Penalties and fines | Deducted on books, never deductible for tax |
Schedule M-1 and Schedule M-3
- Schedule M-1 reconciles book income to taxable income for corporations with total assets under $10 million.
- Schedule M-3 is required for corporations with total assets of $10 million or more and provides a more detailed reconciliation with separate columns for temporary and permanent differences.
:::tip Schedule M-1 Shortcut
Start with book income, then:
- Add back items deducted on books but not on the return (e.g., federal tax expense, excess capital losses, 50% of meals)
- Add back income reported on the return but not on books (e.g., prepaid income received)
- Subtract income on books not on the return (e.g., tax-exempt interest)
- Subtract deductions on the return not on books (e.g., excess tax depreciation) = Taxable income
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Tax computation
The 21% flat rate
Since the Tax Cuts and Jobs Act (TCJA), C corporations pay a flat 21% federal income tax rate on taxable income. There are no graduated brackets.
Example: Kingfisher Industries has taxable income of $2,000,000. Federal tax = $2,000,000 × 21% = $420,000.
Estimated tax payments
A C corporation must make quarterly estimated tax payments if it expects to owe $500 or more in tax. Payments are due on the 15th day of the 4th, 6th, 9th, and 12th months of the tax year.
| Quarter | Due Date (Calendar Year) |
|---|---|
| 1st | April 15 |
| 2nd | June 15 |
| 3rd | September 15 |
| 4th | December 15 |
To avoid an underpayment penalty, the corporation generally must pay the lesser of:
- 100% of current-year tax liability, or
- 100% of prior-year tax liability (not available for large corporations after the first installment)
:::note Large Corporation Rule
A large corporation (taxable income ≥ $1 million in any of the three preceding years) may use the prior-year safe harbor only for the first installment. The remaining three installments must be based on the current-year liability.
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Tax credits
C corporations may reduce their tax liability with various credits:
| Credit | Description |
|---|---|
| General Business Credit (GBC) | An umbrella credit that includes the investment credit, work opportunity credit, low-income housing credit, and others. Subject to a limitation based on tax liability. |
| Research & Development Credit | 20% of qualified research expenditures exceeding a base amount (regular method), or 14% using the alternative simplified credit. |
| Foreign Tax Credit | Credit for income taxes paid to foreign governments, limited to the U.S. tax attributable to foreign-source income. Excess credits carry back 1 year and forward 10 years. |
| Minimum Tax Credit | Corporations that paid AMT in years before 2018 may have minimum tax credit carryforwards to offset regular tax. |
Penalty taxes
Accumulated earnings tax
The accumulated earnings tax discourages C corporations from retaining earnings beyond the reasonable needs of the business to help shareholders avoid dividend taxation.
| Feature | Detail |
|---|---|
| Tax rate | 20% of accumulated taxable income |
| Exemption | First $250,000 of accumulated E&P ($150,000 for personal service corporations) |
| Applies to | Corporations that accumulate earnings beyond reasonable business needs |
| Key defense | Specific, definite, and feasible plans for using the retained earnings |
Example: Illini Security is a C corporation with accumulated E&P of $400,000 and no specific plans for using the excess funds. The IRS may assert the accumulated earnings tax on the amount exceeding $250,000 — that is, on $150,000, resulting in a potential tax of $150,000 × 20% = $30,000.
The accumulated earnings tax is based on the subjective determination that the corporation is retaining earnings to avoid dividends. Corporations should document specific, definite, and feasible business plans for retained funds (e.g., expansion, debt retirement, working capital needs).
Personal holding company (PHC) tax
The PHC tax targets closely held corporations used primarily to hold passive investments.
Two-part test — both must be met:
- Ownership test: More than 50% of the corporation's outstanding stock is owned (directly or constructively) by five or fewer individuals at any time during the last half of the tax year.
- Income test: At least 60% of the corporation's adjusted ordinary gross income is personal holding company income (PHCI) — dividends, interest, rents (sometimes), royalties, and certain personal service income.
| Feature | Detail |
|---|---|
| Tax rate | 20% of undistributed PHC income |
| Avoidance | Pay a deficiency dividend to eliminate or reduce the PHC tax |
| Common PHCI | Dividends, interest, rents (if < 50% of AOGI), royalties, personal service contract income |
Net operating losses (NOLs)
The treatment of corporate NOLs depends on when the loss arose:
| Feature | Pre-2018 NOLs | Post-2017 NOLs |
|---|---|---|
| Carryback | 2 years (general rule) | No carryback (with limited exceptions) |
| Carryforward | 20 years | Indefinitely |
| Limitation | Could offset 100% of taxable income | Limited to 80% of taxable income in the carryforward year |
Example: Bear Co. generates a $500,000 NOL in 2025. In 2026, Bear Co. has taxable income of $400,000 before the NOL deduction. The maximum NOL deduction in 2026 is 80% × $400,000 = $320,000. The remaining $180,000 carries forward indefinitely.
The 80% limitation ensures that a profitable corporation always pays some tax in years when it uses post-2017 NOL carryforwards. This is a frequently tested concept.
Capital loss rules recap
Remember that C corporation capital losses follow different rules from individuals:
- No deduction against ordinary income
- Carryback 3 years, carryforward 5 years
- Always carried as short-term capital losses
- Must be used against capital gains only
Deductible versus nondeductible payments
- Reasonable compensation paid to employee-shareholders is generally deductible by the corporation.
- Dividends are not deductible.
This distinction is a common REG issue because taxpayers may try to label dividends as compensation.
Corporate distributions
A nonliquidating distribution follows a three-step pattern at the shareholder level:
- Dividend income to the extent of current and accumulated earnings and profits (E&P)
- Return of capital to the extent of stock basis
- Capital gain for any excess
The corporation may also recognize gain when it distributes appreciated property.
Liquidation and reorganization themes
Liquidation
- The corporation may recognize gain or loss on property distributed in complete liquidation.
- Shareholders generally treat liquidating distributions as payment in exchange for their stock.
Reorganizations
Some reorganizations can qualify for nonrecognition treatment if statutory requirements are met, but REG usually focuses on the broad idea that not every restructuring creates immediate tax.
When businesses choose a C corporation
C corporations are often preferred when a business needs:
- Multiple classes of equity
- Institutional or venture capital investors
- Easier retention of earnings inside the entity
- The possibility of qualified small business stock (QSBS) treatment if requirements are met
Advantages and disadvantages
| Topic | C Corporation |
|---|---|
| Liability protection | Strong |
| Capital raising | Best among common entity forms |
| Tax regime | Entity-level tax plus possible dividend tax |
| Loss use | Losses stay with the corporation |
| Ownership flexibility | Broadest flexibility |
REG quick hits
- C corporations file Form 1120.
- The corporation is a separate taxpayer.
- Section 351 is central to formation questions.
- Dividends are not deductible; the DRD reduces triple taxation on intercorporate dividends.
- The flat corporate rate is 21%.
- Charitable contributions are limited to 10% of modified taxable income.
- Capital losses cannot offset ordinary income — carryback 3 years, carryforward 5 years.
- Post-2017 NOLs carry forward indefinitely but are limited to 80% of taxable income.
- The accumulated earnings tax and PHC tax are penalty taxes on retained earnings and passive income.
- Distributions depend on E&P and shareholder stock basis.
- Liquidating distributions and reorganizations have their own corporate tax rules.
- Book-to-tax differences are reconciled on Schedule M-1 (small) or M-3 (large).
Bottom line
A C corporation offers strong liability protection and the most financing flexibility, but that comes with entity-level taxation and possible double taxation. On REG, expect questions on formation, E&P, distributions, liquidation, the DRD, book-to-tax differences, NOL limitations, penalty taxes, and the difference between compensation and dividends.