Double Taxation Definition
Double taxation is a term that refers to when a company’s income is taxed and then the distributions or dividends that are paid to shareholders are also taxed. The C-corporation is the only business structure that undergoes double taxation.
Since a C-corporation is an entity established separately from its owners and its shareholders, each individual must pay their own income taxes from any money that is distributed to them.
Double Taxation in Action
Since C-corporations are considered separate legal entities for tax purposes, they pay taxes on corporate earnings at the corporate income tax rate. The United States tax code from the Internal Revenue Service places a double-tax on corporate income with one tax at the corporate level through the corporate income tax and a second tax at the individual level through the individual income tax on dividends and capital gains. Individuals pay income taxes on their dividend income when they receive a share of their profits as shareholders, which are previously taxed at the corporate level.
Thus, corporate income has been taxed twice.
Double taxation is almost always disadvantageous, but it might actually be favorable for shareholders in high tax brackets.
How Can Businesses be Taxed?
Many business owners want to avoid double taxation, however in some instances of higher-earning individuals, it may be beneficial.
The term S-corporation does not refer to a business structure. It’s a tax designation that C-corporations and LLCs can elect.
S-corporations are pass-through entities, meaning the company doesn’t pay taxes on earnings and the entity level. Instead, income and losses flow to each shareholder’s personal returns. This makes S-corporation status beneficial for smaller corporations who need to retain earnings for reinvestment.
One way to have business profits be taxed once is to organize the business as a flow-through or pass-through entity. When a business is organized as a flow-through entity, profits flow directly to the owner or owners
The IRS recoups some tax revenue another way, though. See, S-corporation shareholders that perform duties within the business become employees for tax purposes. The company must pay each of them a reasonable salary based on IRS guidelines.
Consequently, the S-corporation and the shareholder-employees both owe a share of FICA taxes on the salaries.
An LLC can either be a sole proprietorship or a partnership based on its owner (member) count. C-corporations can change to an LLC, but the process is much more involved than electing S-corporation taxation.
Single-member LLCs are sole proprietorships. The IRS calls sole proprietorships “disregarded entities”, meaning they aren’t separate from their owners for taxes. The owner pays individual income taxes on their LLC’s earnings.
Business income flows to the owner’s personal tax return. The owner records income and losses on Schedule C, then transfers their net profit to Form 1040.
Sole proprietors also pay a 15.3% self-employment tax — 12.4% for Social Security and 2.9% for Medicare — on their net earnings to cover both portions of FICA.
Partnerships are the default structure for LLCs with multiple members. Like with sole proprietorships, the partnership itself pays no tax. Each member pays personal income tax in proportion to their ownership stake.
Say you have a three-member LLCs. Member X owns 50%, while members Y and Z each own 25%. Member X pays taxes on 50% of the partnership income, while members Y and Z each pay taxes on 25% of it.
In most cases, each member also pays self-employment taxes on their earnings.
How to Avoid Paying Double Taxation
Maximize Your Retained Earnings
Keeping money in the business — called retained earnings — helps you avoid personal income taxes. Plus, you can reinvest them in the corporation.
But be careful. The IRS can levy an accumulated earnings tax of 20% on any retained earnings they deem to be exceeding a reasonable amount.
IRS Publication 542 sets this limit at $250,000 for most businesses. Many services businesses have a lower limit of $150,000.
Elect S-Corporation Taxation
S-corporation structure lets you dodge taxes at the corporate level. However, you must meet several requirements laid out by the IRS to elect and maintain S-corporation status. Otherwise, the IRS will remove it.
Pay Salaries to Family
The business can employ family members and pay a salary for working in the business.
Pay Salaries to Shareholders
Pay salaries to shareholders that work for the corporation. Salaries are tax-deductible corporate expenses, saving the corporation money while ensuring shareholders benefit from corporate income.