EA Part 2 C-Corporation Taxation: Income, Deductions, and Tax Computation

C-corporations are taxable entities separate from their owners. That separateness — and its consequences — drives nearly every question the SEE Part 2 exam asks about corporate taxation. Understanding how income is measured, how deductions reduce it, and what special rules apply to corporations specifically will put you in a strong position on this domain.

The 21% Flat Tax Rate

The Tax Cuts and Jobs Act of 2017 replaced the graduated corporate rate schedule with a flat 21% rate on all C-corporation taxable income. There is no lower bracket for smaller corporations and no surtax for larger ones. This simplifies the tax computation considerably: corporate tax equals taxable income multiplied by 0.21.

The flat rate also eliminated the personal service corporation (PSC) surcharge that used to apply at 35%. PSCs — law firms, medical practices, accounting firms, consulting businesses owned by their employee-owners — are now taxed at the same 21% rate as any other C-corporation.

Dividends-Received Deduction (DRD)

When a C-corporation receives dividends from another domestic corporation it has invested in, a special deduction reduces the risk of triple taxation (corporate-level tax on the payer, corporate-level tax on the recipient, and shareholder-level tax on the ultimate distribution).

The deduction percentage depends on the recipient's ownership stake in the paying corporation:

• Less than 20% ownership: 50% DRD
• 20% or more but less than 80% ownership: 65% DRD
• 80% or more ownership (affiliated group): 100% DRD

A critical limitation: the DRD cannot exceed the same percentage of the corporation's taxable income — before the DRD — unless taking the full DRD would create or increase a net operating loss. When it would create or increase an NOL, the corporation may take the full deduction regardless of the taxable income limitation.

Exam questions often set up a scenario where the corporation has modest taxable income before the DRD and ask whether the full deduction is available. Check the taxable income limitation first, then check the NOL exception.

Net Operating Loss (NOL) Rules

For tax years beginning after December 31, 2017, C-corporation NOLs:

• Cannot be carried back (the two-year carryback was eliminated for most NOLs by the TCJA, though limited carrybacks exist for farming losses)
• Carry forward indefinitely
• Deduction is limited to 80% of taxable income in the carryforward year

The 80% limitation means a corporation with $1,000,000 of taxable income and a $900,000 NOL carryforward can only deduct $800,000, leaving $200,000 of taxable income. The remaining $100,000 of unused NOL continues to carry forward.

Pre-2018 NOLs follow the old rules: 20-year carryforward, 2-year carryback, and no 80% limitation.

Accumulated Earnings Tax

When a C-corporation retains earnings beyond the reasonable needs of the business specifically to avoid dividend distributions to shareholders, the IRS can impose the accumulated earnings tax (AET) at a rate of 20%.

Every corporation gets an accumulated earnings credit of $250,000 ($150,000 for personal service corporations). Earnings accumulated up to this threshold are presumed to serve a legitimate business purpose. Amounts above the threshold require the corporation to demonstrate a specific, definite, and feasible plan for using the funds — expansion, equipment purchase, debt retirement, and similar objectives qualify.

The AET is an "on top of" tax — it applies in addition to the regular corporate income tax, not instead of it.

Personal Holding Company (PHC) Rules

Personal holding companies are C-corporations where both conditions exist:

1. Ownership test: More than 50% of the stock is owned by five or fewer individuals at any point during the last half of the tax year
2. Income test: At least 60% of adjusted ordinary gross income consists of personal holding company income (dividends, interest, rents in certain cases, income from personal service contracts)

PHC income is taxed at a rate of 20% on undistributed PHC income, after subtracting dividends paid. The PHC tax, like the AET, is designed to prevent using corporate shells to accumulate passive investment income at a lower corporate rate.

Note that a corporation cannot be subject to both the accumulated earnings tax and the personal holding company tax in the same year.

Built-In Gains Tax on C-to-S Conversions

When a C-corporation converts to S-corporation status, assets with unrealized appreciation at the conversion date are subject to the built-in gains (BIG) tax at 21% if those assets are sold within five years of the S election. This prevents a simple workaround where a C-corp converts to S status just before selling appreciated assets to avoid corporate-level tax.

The recognition period runs five years from the first day of the first tax year as an S-corporation. Sales of appreciated assets after the five-year window clear the BIG tax entirely.

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