Under federal income tax laws, a C corporation ( C Corp.) is a separate entity from its shareholders. This means that the corporation pays taxes on any income that's left after business expenses have been paid.

A C corporation reports its profits on tax Form 1120 and pays corporate tax on that income. In addition, if the profits are distributed to shareholders in the form of dividends, the shareholders pay tax on the dividends they receive (creating the much-feared "double taxation" scenario).

In practice, however, a C corporation may not have to pay any corporate income tax even though it is a separate taxable entity. In most incorporated small businesses, the owners are also employees. They receive salaries and bonuses as compensation for the services they perform for the corporation. The corporation then deducts this "reasonable" compensation as a business expense. In many small corporations, compensation to owner-employees eats up all the potential corporate profits, so there's no taxable income left for the corporation to pay taxes on.

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