Tax Returns and Determining Business Income

Spouses who own businesses can often keep a tight lid on finances. This may not be an issue at the onset of marriage, but it means that often, the other spouse is clueless as to how the money is being made. In the unfortunate event of divorce, income becomes a bigger issue when litigating over support and property division. This post is to serve as a primer for two common business entities you may encounter in North Carolina: the C corporation (C corp) and the S corporation (S corp).

First, what are the similarities of both corporations? A corporation is the legal entity that owns the business. The corporation’s directors issue stock to shareholders, who are in turn the owners of the corporation. Shareholders are paid by distributions. Shareholders, as owners, have controlling votes on who is appointed to be on the board of directors and in making major decisions. The day-to-day work is often managed by the officers and executives, who are hired by the board of directors. Both a C corporation and S corporation also require paperwork to be filed: the articles of incorporation and the bylaws. Most of the requirements for setting up both corporations can be found in the North Carolina Business Corporation Act, codified in chapter 55 of the General Statutes.

According to the Internal Revenue Code Subchapter S (codified at 26 U.S. Code §§ 1361-1379), an S corp is a domestic corporation with less than 100 citizen shareholders, that may not be other organizations, and that can issue only one class of stock. The big difference between C and S corps are the tax treatment. The S corporation’s income is passed through to the shareholders to be reported on their individual income tax returns. (26 U.S. Code § 1366). Whereas the standard C corporation must file its own tax return, and the shareholders then pay taxes on the distribution they receive on their personal tax return.

Here’s where you’ll find these differences on tax returns. If you are looking at an individual tax return, you’ll notice Schedule E, part II, has a section for Income or Loss from Partnerships and S Corporations. There, if your spouse is the owner of an S corp, you’ll see them list the corporation and the income or loss from the corporation. This is what is meant when the income of a S corp is passed through and taxed on the individual return. If your spouse received money from ownership interest in a C corporation, you will find that amount on Schedule B, Part II Ordinary Dividends. The amount is typically provided by a 1099-DIV. A shareholder of a corporation may be deemed to receive a dividend if the corporation pays the debt of its shareholder, the shareholder receives services from the corporation, or the shareholder is allowed the use of the corporation’s property without adequate reimbursement to the corporation.

The differences between the two types of corporations are much more extensive and complex than this post will allow. Business interests in divorce and separation are a large aspect of our practice, so if they pertain to your case please speak to a family law specialist that has undergone extensive training with deciphering tax and business filings.