Outside of deciding what products to sell or the type of services your company will offer, the next most important decision is to choose the type of entity your company will become, so you can protect your personal assets. Being a sole proprietorship, becoming an LLC, or being an S or a C corporation all have benefits.
If you form your business as a C Corp, you’ll have to be careful of double taxation as this is the entity type that is at risk. So, what is double taxation, and how could it affect your business and your bottom line? We’re here to help you get out in front of potential issues so you can avoid paying taxes twice.
What Is Double Taxation?
Double taxation is being taxed twice on the same source of income, which happens to C Corps but not to other entities like S Corps and sole proprietors because only C Corps are taxed as a separate entity and pay corporate income taxes on their profits at the corporate level directly.
The other entity types are known as “pass through entities” which means the profits and losses “pass through” from the company to the owner or owners, and the owner or owners pay taxes on their personal income tax rates.
Double taxation can happen internationally when you pay taxes on income to a foreign country as well as here in the USA. The IRS has this guide here to help you avoid this with a foreign tax credit. The IRS also has tax treaties to help prevent this from happening with select countries found here.
Why Double Taxation Happens
Double taxation happens because of accounting, bookkeeping, or business owner errors in two main areas:
- First are the C Corp Taxes. A C Corp files its income taxes by subtracting expenses and losses. Then, it pays taxes on the remaining profits. The current corporate tax rate is set at 21% by the IRS in Publication 542.
- Next are the Shareholder Taxes. If a shareholder or owner takes a salary or wages from a C Corps’ corporate earnings, they must also pay personal income taxes on those earnings.
The result if you do both above is that your earnings will be taxed twice: first on the corporate earnings, then on the dividends or wages you earn from the business. That is double taxation because of having a C Corp.
Example of Double Taxation
Let’s imagine that your C Corp will make $100,000 in profit this year. The corporate tax rate is 21%, so your business will have to pay $21,000 in corporate taxes to the IRS.
You and your shareholders will receive dividends from the rest of the $79,000, but you’ll each have to pay personal income taxes on those dividends. Because you’re the owner, you’ll pay personal income taxes on the salary you draw. By knowing about double taxation ahead of time, you can set up a plan to avoid paying taxes twice.
How to Avoid Double Taxation
There are three strategies you can use to avoid double taxation, including retaining corporate earnings, paying salaries instead of dividends, and splitting income.
Retaining Corporate Earnings
Retaining corporate earnings helps you avoid double taxation by keeping profits in the business rather than distributing them to shareholders as dividends. If shareholders don’t receive dividends, they’re not taxed on them, so the profits are only taxed at the corporate rate.
If you and your shareholders rely on company profit for income, retaining corporate earnings probably isn’t a good idea. But if you can afford to reinvest the cash, you could grow your business.
Pay Salaries Instead of Dividends
When you pay salaries instead of dividends, you distribute profit as salaries or bonuses instead of as dividends. Employees will have to pay personal taxes on any salaries or bonuses they earn, but they’ll be deductible expenses for your business.
Income Splitting
Income splitting is a double taxation avoidance strategy where a business owner withdraws from the corporate profit what they need in cash but leaves the rest of the profits in the corporation.
Because progressive tax brackets affect C Corps and individuals, income splitting can minimize double taxation. By taking a tax-deductible salary and leaving the rest of the profit for reinvestment, you reduce your personal gross income and the business’s taxable income.
Double Taxation Is Not a Reason to Avoid Being a C Corp
Double taxation can seem like a penalty for C Corp owners, but by incorporating the strategies from this guide, business owners can take advantage of the C Corp structure, while minimizing the effects of double taxation.
So don’t let the fear of double taxation stop you from forming a C Corp as your business structure. There are multiple advantages C corps have over other entity types including:
- Limited liability and separate legal identity. C Corp formations provide limited liability for their owners. Shareholders are not personally liable for the corporation’s debts, unless a judge decides to “pierce the corporate veil,” as the corporation has a separate legal identity, meaning it exists independently from its owners. This separation shields shareholders from personal financial risks.
- Tax advantages compared to those of sole proprietors or partnerships. C corps don’t pay self-employment taxes on profits, so C Corp businesses have more flexibility with deductions, salaries, and dividend distributions.
- Being attractive for investors who normally prefer C corps due to their well-established legal precedents and widespread acceptance by venture capitalists.
While double taxation is a problem that can affect C Corp business structures, a C Corp offers benefits that often outweigh the risks, especially for companies aiming for growth. By knowing about double taxation and the causes, you can be proactive and avoid being taxed twice while enjoying the benefits of a C Corp business structure.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
