Corporate Tax

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Corporate Tax?

Corporate tax refers to the amount charged by the government on a company’s profits or net income. It is an essential source of revenue for the government. It is also known as corporation tax.

Corporation tax is calculated as per the specific norms of a country. Firms’ taxable incomes comprise profits from the sale of goods or services, commissions, interests, capital gains, and rents. To obtain the applicable taxable income, allowed deductions and exemptions are deducted from the profits.

Key Takeaways

  • Corporation tax is the charges levied by a government on the taxable income of registered private or public corporations.
  • Governments revise corporation tax rates every year to boost the nation’s overall economic growth.
  • According to The Internal Revenue Service (IRS), C corporations are required to report business returns by filing Form 1120. However, a pass-through taxation entity or S corporation is required to file Form 1120-S— to avoid double taxation.

Corporate Tax

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Corporate Tax Explained

A corporation is a separate legal entity that holds independent liabilitiesLiabilitiesLiability is a financial obligation as a result of any past event which is a legal binding. Settling of a liability requires an outflow of an economic resource mostly money, and these are shown in the balance of the company.read more. It earns profit from different sources such as sales revenue, capital gains, commissions, interests, and dividends. The government charges a corporation tax on the profits.

The United States currently levies a flat 21% corporation tax on the Taxable Income of the registered companies. In 2017, the US corporation tax rate was reduced from 35% to 21%. On average, corporations pay 25.89% for local, state, and federal taxes.

It is an essential source of revenue for the government. The corporation tax rate undergoes annual revisions around the globe. The amendments prioritize the growth of corporations and the economyEconomyAn economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read more. It is often lowered to allow expenditure on business development and capital enhancement. It is important to note that corporation tax is different from income tax charged on an individual’s personal earnings.

A “C corporationC CorporationAccording to US tax laws, any corporation that is not a S corporation is considered a C corporation, which has a different legal status and is taxed accordingly. It has its own articles of incorporation that defines its activities and is held by the shareholders, while its liability is limited.read more” has to report corporate returns by filing Form 1120. However, if a company files its returns using Form 1120-S, it is an “S corporationS CorporationS corporation refers to the special status entity exempted from paying corporate tax, which allows shareholders to be taxed only once when they receive the benefits by follow-through taxation, thereby avoiding double taxation at the corporate level under a special chapter of IRS so that all the rules specified in the chapter shall be complied with.read more.” S corporations are pass-through taxation entities. These corporations do not pay any tax. Instead, the profits and losses are passed onto owners’ personal tax returns. The firms’ taxes are paid at an individual level by the owners.

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Formula

For determining the corporation tax, the company’s taxable income has to be ascertained. Consequently, the following formula is used to compute the corporate tax amount:

corporate tax formula

The Adjusted Gross IncomeAdjusted Gross IncomeAdjusted Gross Income (AGI) is calculated from the gross income. It represents the net income earned by an individual in a year, including wages, capital gains, and retirement distributions after deducting above-the-line deductions. It determines an individual's taxable income by determining deductions or credits a person is eligible to receive.read more (AGI) can be obtained by deducting the applicable adjustments from gross income. The Gross IncomeGross IncomeThe difference between revenue and cost of goods sold is gross income, which is a profit margin made by a corporation from its operating activities. It is the amount of money an entity makes before paying non-operating expenses like interest, rent, and electricity.read more is the total income arising from goods sales, commissions, interests, rent, and other sources. The applicable adjustments include early withdrawal penalties, employee expenses, operation expenses, and other business expenses.

The Internal Revenue Service (IRS) allows itemized deductionsItemized DeductionsAn itemized deduction is an eligible expenditure incurred by the individual taxpayers on various products or services for claiming these expenditures on FIT (federal income tax) returns solely to reduce their tax implications. These are multiple sorts of tax-deductible expenditures incurred throughout the year.read more, but if the taxpayer does not claim that, the standard deduction will be applied.

Corporate Tax Calculation

Now, let us go through the basic steps involved in the calculation of the corporate tax:

  1. First, find the adjusted gross income and the allowed deductions to compute the taxable income.
  2. Evaluate the corporation’s taxable income using this formula: Taxable income = Adjusted Gross Income – All Applicable Deductions.
  3. Multiply the corporation tax percentage with the taxable income to determine the corporation tax liability: Corporate Tax=Taxable Income × Corporate Tax Rate.

Example

XYZ Corporation has earned a net profit of $50,000 during the current financial year. The company is allowed up to $5000 in deductions. The applicable corporation tax rate is 21%. Now, calculate the corporation tax liability.

Solution:

Corporate Tax = Taxable Income × Corporate Tax Rate

Taxable Income = Adjusted Gross Income – All Applicable Deductions

Taxable Income = 50000 – 5000 = $45000

Corporate Tax = 45000 × 21% = $9450

Thus, XYZ Corporation is liable to pay $9450 as corporation tax.

Corporate Tax Planning

Firms can legitimately reduce the taxable income by utilizing tax planningTax PlanningTax planning is the process of minimizing the tax liability by making the best use of all available deductions, allowances, rebates, thresholds, and so on as permitted by income tax laws and rules imposed by a country's government. It contributes to better cash flow and liquidity management for taxpayers, as well as better retirement plans and investment opportunities.read more alternatives—not to be confused with unethical means—non-payment or tax evasionTax EvasionTax Evasion is an illegal act in which the taxpayers deliberately misreport their financial affairs to reduce or evade the actual tax liability. This includes using multiple financial ledgers, hiding or representing lesser income, gains, or profits than actually earned, overstating deductions, & failing to file returns. read more. By planning ahead, firms can avoid paying excessive taxes.

Tax consultants and chartered accountants decrease tax liability by using various deductions, credits, government subsidies, and exemptions approved by the Internal Revenue Service (IRS). These professionals have an in-depth knowledge of tax regulations, tax management, and tax planning.

Advantages

We all have heard the cliché, “when businesses flourish, the nation’s economy grows.” But how does this work exactly? The answer is corporation tax.

Some of its other benefits are discussed below:

Deductions

According to the Internal Revenue Service (IRS), the following expenses can be deducted from taxable incomeTaxable IncomeThe taxable income formula calculates the total income taxable under the income tax. It differs based on whether you are calculating the taxable income for an individual or a business corporation.read more:

Frequently Asked Questions (FAQs)

What is corporate tax planning?

Corporation tax planning is the process of curtailing taxable income in an ethical manner. This is achieved by considering various allowable deductions and exemptions in accordance with the IRS. Chartered accountants facilitate tax planning. They suggest multiple ways of reducing liability compliant to regulations.

How to pay corporate tax?

The corporation tax is a form of direct tax applied to a firm’s taxable income. The registered company must file IRS Form 1120 to report corporate tax returns. Consequently, the corporation has to pay the due corporation tax every quarter. The payment has to commence before the 15th.

Who pays corporate taxes?

Every registered company, both private and public, has to pay the corporation tax. However, the responsibility falls on shareholders—a portion of their profits are used to clear tax liabilities.

This has been a guide to what is Corporate Tax and its Meaning. Here we discuss corporate tax formula, calculation, examples, planning, and advantages. You can learn more from the following articles –