What is Double Taxation?
Double taxation is a tax principle under which an individual or business pays income taxes twice on the same asset, financial transaction, or income source.
The term double taxation refers to the multiple layers of tax imposed by subchapter C of the Internal Revenue Code. Under subchapter C, a company’s income is taxed, and then any distributions or dividends paid to shareholders are also taxed. The C-corporation is the only business structure that undergoes double taxation.
How Does Double Taxation Work?
Since C-corporations are considered separate legal entities for tax purposes, they pay taxes on earnings at the corporate income tax rate.
Each shareholder pays personal income taxes at the individual level on distributions or capital gains from the sale of shares.
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.
See, the corporate tax rate is 21% as of 2019. Say that a company’s taxable income was $300,000 for 2019. Without double taxation, an individual would be in the second-highest tax bracket, 35%. They’d pay $75,924 in income taxes.
But if they were a shareholder of a corporation that earned $300,000, that $300,000 would be taxed at 21% or $63,000 in taxes.
If the corporation then paid out $50,000 in dividends, the shareholder would pay $4,342 in federal income taxes on corporate earnings from the business. Altogether, the total income taxes paid would be $67,342 — a savings of $8,582.
How Are Other Business Structures Taxed?
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 income tax returns. This makes S-corporation status beneficial for smaller corporations who need to retain earnings for reinvestment.
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.
A Limited Liability Company can either elect to be taxed as 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 personal 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 LLC. 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 reduce your tax burden and 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 small 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 shareholders and family members that work for the corporation. Salaries are tax-deductible business expenses, which reduce corporate profits while ensuring shareholders benefit from the income from the business.