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 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 could it affect your business and your bottom line?
What Is Double Taxation?
Double taxation is precisely what it sounds like — being taxed twice on the same source of income. Unlike LLCs, sole proprietors, and S corps, which don’t pay business taxes directly, C corps must pay business taxes. Let’s break it down:
- C Corp Taxes: C cop files its income taxes, subtracting expenses and losses. Then, it pays taxes on the remaining profits. The current corporate tax rate is set at 21% by the IRS.
- 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.
So, if you own a C corp, your earnings will be taxed twice—first on the corporate earnings, then on the dividends or wages you earn from the business.
Example
Let’s imagine that your C corp company will make $100,000 in profit this year. The corporate tax rate for 2024 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 Avoid Double Taxation
C corps can’t escape this tax maze entirely, but they can adjust their strategies:
- 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.
Despite the possibility of double taxation, some may still choose C corporation for the following advantages:
- Limited liability and separate legal identity: C corps provides limited liability for their owners. Shareholders are not personally liable for the corporation’s debts. The corporation has a separate legal identity, meaning it exists independently from its owners. This separation shields shareholders from personal financial risks.
- Tax advantages for smaller business owners: Unlike sole proprietors or partnerships, C corps don’t pay self-employment taxes on profits. C corps have more flexibility with deductions, salaries, and dividend distributions.
- Attractive for investors: Investors often prefer C corps due to their well-established legal precedents and widespread acceptance by venture capitalists.
The Bottom Line
While double taxation is a big consideration, the C corp structure offers benefits– especially for companies aiming for aggressive growth. One could argue that regardless of double taxation, C corps provides many advantages for large and small business owners.
