What is double taxation?
Just as the term implies, double taxation is when taxes are paid twice on the same income. There are three scenarios where the law of double taxation applies:
C corporation, or C corp, profits are taxed at both the shareholder and corporate levels. In this scenario, the business must pay corporate income taxes on profits. All shareholders must then pay individual income taxes on dividends received from those profits.
International trade or investments where the income is both a U.S. tax and foreign tax liability. Many companies conduct business internationally, where profits are earned in one country, but the business’s headquarters are in another. If there is no reciprocal agreement or treaty between the countries, businesses can end up paying taxes in both locations.
Traditional IRAs that include after tax contributions and earnings. With a tax free traditional IRA account that includes after-tax contributions plus earnings, steps can be taken to identify the tax free contributions versus the after-tax contributions versus any subsequent earnings, thus avoiding tax on the original tax free contributions when later making withdrawals.
While the last two tax situations are not uncommon, small business owners like you are probably more concerned with how double taxation affects your corporation and how you can reduce your federal income tax burden.
Double taxation on corporations
Businesses that are registered as C corps (and LLCs that elect to be treated as corporations) are taxed twice on business profits. The corporation first pays taxes on its profits, but then stockholders must pay personal income taxes on the dividends paid from the company’s profits.
For example, if your corporation had $100,000 in profits last year and the corporate tax rate is 21%, your business owes the IRS $21,000 in taxes. But, on top of that, you and your shareholders are required to pay taxes individually on any dividends and wages you received from the remaining $79,000. These are taxed at your personal income tax rate, which can range from 12 to 37 percent.
Other types of business entities such as partnerships, sole proprietors, and non-corporate LLCs only pay income tax one time. These business structures use pass-through taxation since the income “passes through” the business down to the owners or individuals who are then taxed directly.
Suggested resource: C Corp vs. LLC: Which Is Better for Early-Stage Entrepreneurs?
Benefits to operating under a C corp structure
If structuring your small business as a C corporation means paying taxes twice, why is the corporate structure appealing? Despite the double taxation requirement, your business can realize the following benefits as a C corp:
C corps can raise additional capital for their business by selling shares to an unlimited number of shareholders.
For example, Tom and Mike establish a boat dealership together with an investment of $200,000 apiece under the C corp structure. Their friends and family are optimistic the business will do well and become shareholders by investing $1,000 apiece. The business attracts a total of 50 shareholders, infusing the business with another $50,000.
In a C corp, owners and shareholders are not responsible for debts and obligations that surpass the amount of their original investments.
Let’s clarify this benefit by revisiting Tom and Mike’s boat dealership scenario. Unfortunately for their business, the economy has fallen into a major recession, causing boat sales to decrease dramatically. As a result, the dealership goes into debt to the tune of $1 million. However, under the C corp structure, Tom and Mike are each only responsible for their initial $200,000 investment, while their shareholders are only out their original $1,000 investment.
C corps can deduct the cost of benefits such as life, health, and disability insurance. The shareholders in the business who are employed don’t have to pay taxes on the benefits they receive from the C corp.
Comparing legal entity taxation benefits and drawbacks
As you consider if a C corp is the right fit for your business, here is a comparison of the advantages and disadvantages of filing taxes under each of the legal entities.
|C corp||No self-employment tax on profits.
The flat tax rate of 21% may be lower than the individual’s tax bracket rate.
Tax-free benefits such as deductions for retirement plans and insurance.
|Double taxation on both the corporate and individual levels.
Owners may have increased tax burden since they can’t take the same credits and deductions (the QBI deduction for example) as individual taxpayers.
Tax filings are more complicated.
|S corp*||Avoids double taxation by passing income through to owners.
Owners can take deductions for health insurance and retirement plans.
Owners are only subject to payroll taxes on wages and not on corporate profits distributed to them.
|Not treated equally by each state. Some States have separate filing requirements in addition to Federal filing requirements.
If an S corp revokes its status, it is automatically taxed as a C corp unless the business applies for a different entity type.
|Partnership||Partners can deduct unreimbursed business expenses.
Partners pay income tax once and only on their percentage share of profits.
|Each partner must set aside enough money to pay quarterly estimated income taxes on their percentage share of annual profits.
Profits are taxed whether partners receive them or not.
Partners must pay self-employment taxes.
|Sole proprietorship/LLC||Can use net profit instead of wages to meet thresholds for health and retirement plan contributions.
Sole proprietors only pay income tax once.
Business and personal filings are combined on one tax return.
|Taxed on all profits of the business on a personal level.
Sole proprietors must pay self employment taxes.
*Note: An S corporation (or S corp) technically isn’t a business type, since your business can’t become an S corporation right from the start—you must first form either an LLC or C corp and then apply for S corp status. Learn more about S corporations.
How you can avoid or minimize double taxation on your business
Now that you are familiar with the concept of double taxation, let’s take a look at how you can avoid this situation for your small business.
The easiest approach is avoiding the C corp structure altogether. While this entity offers the advantages listed above, you may find that the double taxation requirement is just not economically feasible for your business.
However, if you still feel that structuring as a C corp is best for your business, there are ways you can reduce your corporate tax obligations.
Put more of your business income into retained earnings. This is a better option for newly formed businesses, since the income should fund company growth. However, keep in mind that you will need to reserve a part of the income to pay dividends to your shareholders. You will also need to justify retained earnings over $250,000 in order to avoid the Accumulated Earnings Tax.
Pay salaries instead of dividends. This action reduces the dividend tax for individuals. Instead, they will offset personal income tax through payroll tax withholding. Plus, your business can still deduct the salary, bonus and payroll tax expenses on its tax return.
Income splitting. Taking a portion of the profits out for salaries and reinvesting the rest can reduce the owner’s gross income and the corporation’s taxable income. You can also draw a salary in addition to hiring family members and other employees. Even though you still have to pay taxes on your salary, you will reduce your double tax obligation.
Take out a loan from the business. Money borrowed from the business is not treated the same as a taxable dividend and is an effective option if you don’t have to pay many shareholders. However, tax authorities may closely scrutinize the transaction, so have a repayment plan with a reasonable interest rate in place.
Switch to an S corp structure: Once your corporate structure is in place, it’s easy to ask the IRS to treat it as an S corp for tax purposes. Both types of corporations have limited liability perks, but the profits in the S corp pass through to shareholders, avoiding a double taxation situation. Before requesting S corp treatment, ensure you meet the requirements which includes having less than 100 shareholders with one class of stock.
Should you consider the C corp structure for your business?
While the double taxation requirements of a C corp may have you hesitating to use this structure, there are other benefits and drawbacks to consider.
You should stick to the C corp structure if the following applies:
You are seeking investors in the business and want to sell shares of stock to help raise capital.
You want the strongest personal liability protection for everyone involved in the business.
Your business and personal tax status can handle the double taxation obligations without jeopardizing profits.
On the other hand, the double-taxed C corp structure may not be a good fit for your company for these reasons:
It would be a financial hardship for you to pay taxes at both the corporate and individual levels.
You don’t plan on having shareholders in your business.
You plan on taking profits out of the company rather than reinvesting them.
How Bench can help
After learning about the varying taxation requirements of the above business entities, you may be considering switching your business to a different tax structure. This switch may also require a change in how you do your company’s bookkeeping and tax filings.
With Bench, you can rest assured that your business’s tax structure transition goes smoothly with our expert bookkeeping team. Even after your business has successfully migrated to the new structure, Bench will ensure that your books are kept accurate and up-to-date. Our tax filing solutions can also give you peace of mind that your corporate taxes are filed correctly and on time.
If you need help deciding which entity type is best for your business, download our free business entity guide.
Does double taxation make sense for your bottom line?
Deciding on a structure for your small business is an important decision that affects your bookkeeping and taxes. If you are considering the C corp structure for your business, the double taxation obligation can take a toll on your overall bottom line. However, actions like paying salaries instead of dividends and reinvesting profits can help you minimize the corporate tax burden and keep your business on solid financial ground.