If you’re operating a business in the United States, you know that paying taxes is something you can’t avoid. However, for businesses that are structured as C-corporations, an issue known as double taxation can make you feel like you’re paying more than your fair share.
The following guide takes a look at how double taxation works and the impact it can have on business owners. We’ll also discuss a few simple tax-reduction strategies you may want to consider.
What is Double Taxation?
The term “double taxation” refers to a scenario that occurs when taxes are owed on the same income twice. This occurs when businesses that are structured as C-corps (also just known as “corporations”) pay out dividends.
When a corporation earns a profit, it must pay income taxes at the corporate rate before any proceeds can be passed on to shareholders in the form of dividends. Once shareholders receive their dividends, they are also taxed on the income at their current rate.
Since the current corporate tax rate is 21% and the top individual tax rate is 37%, this means that the same dollar could be taxed at a total of 58%. It’s no surprise, then, that this can become a serious situation for both corporations and shareholders.
Strategies for Avoiding Double Taxation
While the potential rate of taxation may be alarming, there is some good news. With a bit of proactive tax planning, you can put some strategies in place to avoid being double taxed. Here are a few options to consider.
Retain Earnings
While corporations must pay taxes on all earnings, shareholders are only taxed when dividends are distributed to them. If you choose to retain earnings instead of paying them out, the money will only be taxed once, at the corporate rate.
If you and your other shareholders don’t need the funds right away, you may want to keep them inside the corporation or reinvest back into the business.
Pay Salaries Instead of Dividends
For shareholders who also work within your company, consider paying higher salaries instead of distributing profits as dividends. In this case, the individual will be taxed on the income at their personal rate and the corporation can deduct the expense.
While this can be a smart tax-savings strategy, it is important to note that the IRS requires all salaries to be “justifiable,” putting some limitations on how much you can reasonably pay.
Borrow from Your Business
If you need to access cash from your corporation, it may make sense to take a loan from the business instead of a dividend, since the loan won’t be taxable. Just make sure that it’s not obviously a dividend in disguise. For example, the IRS will want to see that you’re consistently repaying the loan and paying your business a reasonable interest rate.
Review Your Business Structure
One of the justifications for double taxation is that C-corps are considered their own legal entity. S-corps and LLCs are also considered separate legal entities, but they are “pass-through entities.” This means that the income passes through to the business owner’s individual tax return, avoiding double taxation.
These business structures offer the same liability limitations as corporations, without the extra tax headaches. As long as you don’t plan to have more than 100 shareholders or shareholders who are non-U.S. citizens or residents, switching your business structure could be a viable solution.
Consult with a Tax Professional
Now that you know the answer to the question, “What is double taxation?” you may be wondering how this could impact your business. If you’re located in Texas, the experts at Gurian CPA are here to help you with all of your business tax questions and concerns. Contact us today to schedule a consultation.
