CPA Exam — REG (Regulation)Federal Taxation of EntitiesEasy
A technician, operating a small independent repair shop, is considering incorporating the business as a C corporation. Which of the following statements regarding the tax implications of forming a C corporation is most accurate?
- AThe formation of a C corporation always results in immediate recognition of gain or loss for the contributing shareholders.
- BC corporations pass through all their income, gains, losses, and deductions directly to their shareholders.
- CShareholders of a C corporation are subject to a second level of taxation when corporate earnings are distributed as dividends.
- DC corporations are generally exempt from federal income tax if their gross receipts are below a certain threshold.
Show answer & explanationAnswer & explanation
Correct answer: C. Shareholders of a C corporation are subject to a second level of taxation when corporate earnings are distributed as dividends.
C corporations are subject to federal income tax at the corporate level. When the corporation distributes its after-tax earnings to shareholders as dividends, those dividends are taxed again at the shareholder level, leading to "double taxation."
Why the other options are wrong
- A. Formation of a C corporation can be tax-deferred under IRC Section 351 if certain conditions (e.g., control immediately after the exchange) are met.
- B. This describes the tax treatment of pass-through entities like S corporations or partnerships, not C corporations.
- D. C corporations are subject to federal income tax regardless of their gross receipts, unlike some small businesses that might qualify for simplified reporting.
C Corporation Double Taxation
C corporations face double taxation: once at the corporate level on their profits, and again at the shareholder level when those profits are distributed as dividends.
- Corporate profits are taxed first.
- Distributions (dividends) to shareholders are taxed again.
- This is a major disadvantage compared to pass-through entities.
Memory trick: Corporate Profit Pockets Pay Twice.