The most important decision you make when you start your business — outside of setting the product or service you’ll be selling — might be the corporate business structure you choose. You could form as a sole proprietorship, an LLC, an S corporation or a C corporation. But if you form as a C corp, you’ll have to watch out for double taxation.
So what is double taxation, and how it could affect your business and your bottom line?
What Is Double Taxation?
Double taxation is what it sounds like — being taxed twice on the same source of income.
When a business is organized as a C corp, it’s recognized as a separate tax-paying entity. LLCs, sole proprietorships, and S corps don’t pay business taxes. Instead, the business’s profits are reported on the owners’ personal tax returns, and the owners pay taxes on those earnings.
C corps must pay business taxes, though. C corps pays corporate income tax on its profits, and then it pays its shareholders dividends from the after-tax income. Shareholders then pay personal income taxes on those dividends.
If a shareholder or owner takes a salary or wages from a C corp’s corporate earnings, they must also pay personal income taxes on those earnings. So if you own the C corp, your earnings will be taxed twice—first on the corporate earnings, then on the dividends or wages you earn from the business.
Let’s imagine that your C corp company will make $100,000 in profit this year. The corporate tax rate for 2021 is 21%, according to the Tax Foundation, 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. And because you’re the owner, you’ll pay personal income taxes on the salary you draw.
How to Make Sure You’re Not Taxed Twice
If you don’t want to pay business taxes and personal taxes on the same earnings, one of these strategies could help you reduce or eliminate double taxation issues.
- Retaining corporate earnings. You can avoid double taxation by keeping profits in the business rather than distributing it 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. You can 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.
- Split income. Income splitting is a strategy in which a business owner withdraws from the corporate profit what they need to support their lifestyle 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 can seem like a penalty for C corp owners, but by incorporating these strategies, business owners can take advantage of the C corp structure while minimizing the effects of double taxation.