Publication 542: An Explanation for Corporations

IRS Publication 542 serves as the federal tax guide for domestic corporations, offering supplemental information to the instructions for Form 1120, the U.S. Corporation Income Tax Return. This publication details the general tax laws applicable to these entities. The document is designed to explain complex tax law in more accessible language, though it does not cover every possible scenario or replace the law itself.

This article provides an overview of the concepts in Publication 542. It is structured to help business owners understand the corporate tax lifecycle, from formation to paying taxes and distributing profits.

Corporate Formation and Tax Structure

For federal income tax purposes, a business structured as a corporation is treated as a distinct legal entity separate from its owners. This structure includes entities incorporated under state law and other businesses that elect to be taxed as corporations by filing Form 8832, Entity Classification Election. The default classification for an incorporated business is a C corporation.

A key tax event for a corporation is its formation. Under Internal Revenue Code Section 351, no gain or loss is recognized on the transfer of property to a corporation if the transferors are in “control” of the corporation immediately after the exchange. Control is defined as owning at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock.

This provision is intended to encourage business formation by preventing the initial act of funding a new enterprise from becoming a taxable event. If the transferor receives anything other than stock, such as cash or other property (referred to as “boot”), gain may need to be recognized up to the value of the boot received. Both the corporation and the shareholders involved in a Section 351 exchange must attach a statement to their tax returns detailing the transaction.

Upon formation, a decision is whether to remain a C corporation or elect to become an S corporation. A C corporation is taxed on its profits at the corporate level, and then shareholders are taxed again on any dividends they receive, a system called “double taxation.” In contrast, an S corporation is a pass-through entity whose profits, losses, deductions, and credits are passed directly to shareholders. To qualify for S corporation status, a business must meet criteria including having no more than 100 shareholders, who must be U.S. citizens or residents, and having only one class of stock.

Determining Corporate Taxable Income

A corporation’s taxable income calculation begins with its gross income. For most corporations, this starts with gross receipts from sales, reduced by the cost of goods sold (COGS), and includes other income like interest, rent, and gains from asset sales.

From gross income, a corporation subtracts allowable business deductions to arrive at its taxable income. These deductions represent the ordinary and necessary expenses incurred in carrying on the trade or business. A deduction for many corporations is the Cost of Goods Sold, which represents the direct costs of producing the goods it sells, including the cost of raw materials and direct labor.

Other common deductions include:

• Employee compensation, such as salaries, wages, and retirement plan contributions
• Rent paid for office or factory space
• Interest on business loans
• State and local taxes
• Insurance premiums for business-related coverage
• Professional fees for legal and accounting services
• Advertising costs

Depreciation is a deduction that allows a corporation to recover the cost of tangible assets over their useful lives, spreading the cost over several years instead of deducting it all at once. However, IRC Section 179 allows businesses to expense the full cost of certain qualifying property in the year it is placed in service, up to a specified limit. For 2025, the maximum Section 179 expense deduction is $1,250,000, subject to a phase-out threshold for total equipment purchases.

Additionally, bonus depreciation allows for an additional first-year deduction for the cost of new and used qualified property. For 2025, the bonus depreciation rate is 40%.

Calculating and Paying the Corporate Tax

C corporations are subject to a flat federal income tax rate of 21% on their net profits. This rate is applied to the taxable income figure after all allowable deductions are subtracted from gross income.

After the initial tax liability is calculated, it can be reduced by any applicable tax credits. Unlike deductions, which reduce taxable income, tax credits provide a dollar-for-dollar reduction of the tax itself. Common corporate tax credits are part of the General Business Credit, which can include credits for research and development activities or for providing paid family and medical leave, and are aggregated on Form 3800.

Corporations are required to pay their income tax throughout the year as estimated tax payments if they expect to owe $500 or more in tax for the year. These payments are made in four equal installments, due on the 15th day of the 4th, 6th, 9th, and 12th months of the corporation’s tax year. For a calendar-year corporation, the dates are April 15, June 15, September 15, and December 15.

To calculate the required quarterly payment, a corporation can pay 25% of the tax expected for the current year or 25% of the tax shown on the prior year’s return. The prior year must have been a full 12-month period and showed a tax liability. Failure to pay enough tax by the due date of each installment can result in an underpayment penalty, calculated on Form 2220, Underpayment of Estimated Tax by Corporations.

Filing the Corporate Tax Return

The annual income tax return is filed using Form 1120, U.S. Corporation Income Tax Return. To complete this form, a corporation must gather its financial data for the year, including income statements and balance sheets. This data is used to report total income, deductions, taxable income, tax liability, and estimated tax payments.

Form 1120 summarizes the corporation’s income and deductions to arrive at taxable income. The form reconciles the total tax with payments and credits to determine an overpayment or a balance due. The form also includes schedules for more detailed information, such as Schedule L for balance sheets and Schedule M-1 to reconcile book income with tax income.

The completed return can be filed by mail or electronically. The IRS may require electronic filing for corporations that file 10 or more returns annually. E-filing offers faster processing and confirmation of receipt.

The filing deadline for Form 1120 is the 15th day of the 4th month after the end of the corporation’s tax year. For a calendar-year business, the due date is April 15. An automatic six-month filing extension can be requested with Form 7004. It is important to note that an extension to file is not an extension to pay; the corporation must still pay its estimated tax liability by the original due date to avoid penalties and interest.

Shareholder Distributions and Special Taxes

After a C corporation pays its income tax, it may distribute remaining profits to shareholders. These distributions are subject to the “double taxation” inherent in the C corporation structure.

A distribution is classified as a dividend to the extent that the corporation has current or accumulated “earnings and profits” (E&P), a tax-specific measure of a company’s ability to pay dividends. Dividends are distinct from employee salaries, which are deductible expenses for the corporation. For the shareholder, qualified dividends are taxed at lower long-term capital gains rates if certain holding period requirements are met.

If a corporation makes a distribution that exceeds its current and accumulated E&P, that excess portion is treated as a non-taxable “return of capital.” A return of capital reduces the shareholder’s basis in the stock, and once the basis is zero, any further distributions are taxed as a capital gain. The corporation must report the breakdown of distributions on Form 1099-DIV and may need to file Form 8937 if a return of capital occurs.

The tax code includes penalty taxes to discourage corporations from avoiding the tax on dividends by holding onto profits indefinitely. The primary penalty is the Accumulated Earnings Tax (AET). This tax is imposed at a rate of 20% on corporations that accumulate earnings beyond the reasonable needs of the business with the purpose of avoiding income tax for their shareholders.

A corporation can accumulate up to $250,000 ($150,000 for certain personal service corporations) without justification. Amounts retained above this threshold must be for specific, documented business needs, such as planned expansions, debt retirement, or working capital, to avoid the AET.