Tax season may not be your favorite time of year. But imagine if you had to pay income tax on your business profits twice in the same period. That's exactly what many corporate business owners are required to do under the IRS tax policy of double taxation.
Just as the term implies, double taxation is when taxes are paid twice on the same income. There are three scenarios where the law of double taxation applies:
While the last two tax situations are not uncommon, small business owners like you are probably more concerned with how double taxation affects your corporation and how you can reduce your federal income tax burden.
Businesses that are registered as C corps (and LLCs that elect to be treated as corporations) are taxed twice on business profits. The corporation first pays taxes on its profits, but then stockholders must pay personal income taxes on the dividends paid from the company's profits.
For example, if your corporation had $100,000 in profits last year and the corporate tax rate is 21%, your business owes the IRS $21,000 in taxes. But, on top of that, you and your shareholders are required to pay taxes individually on any dividends and wages you received from the remaining $79,000. These are taxed at your personal income tax rate, which can range from 12 to 37 percent.
Other types of business entities such as partnerships, sole proprietors, and non-corporate LLCs only pay income tax one time. These business structures use pass-through taxation since the income "passes through" the business down to the owners or individuals who are then taxed directly.
Suggested resource: C Corp vs. LLC: Which Is Better for Early-Stage Entrepreneurs?
If structuring your small business as a C corporation means paying taxes twice, why is the corporate structure appealing? Despite the double taxation requirement, your business can realize the following benefits as a C corp:
C corps can raise additional capital for their business by selling shares to an unlimited number of shareholders.
For example, Tom and Mike establish a boat dealership together with an investment of $200,000 apiece under the C corp structure. Their friends and family are optimistic the business will do well and become shareholders by investing $1,000 apiece. The business attracts a total of 50 shareholders, infusing the business with another $50,000.
In a C corp, owners and shareholders are not responsible for debts and obligations that surpass the amount of their original investments.
Let's clarify this benefit by revisiting Tom and Mike's boat dealership scenario. Unfortunately for their business, the economy has fallen into a major recession, causing boat sales to decrease dramatically. As a result, the dealership goes into debt to the tune of $1 million. However, under the C corp structure, Tom and Mike are each only responsible for their initial $200,000 investment, while their shareholders are only out their original $1,000 investment.
C corps can deduct the cost of benefits such as life, health, and disability insurance. The shareholders in the business who are employed don't have to pay taxes on the benefits they receive from the C corp.
As you consider if a C corp is the right fit for your business, here is a comparison of the advantages and disadvantages of filing taxes under each of the legal entities.
*Note: An S corporation (or S corp) technically isn't a business type, since your business can't become an S corporation right from the start—you must first form either an LLC or C corp and then apply for S corp status. Learn more about S corporations.
Now that you are familiar with the concept of double taxation, let's take a look at how you can avoid this situation for your small business.
The easiest approach is avoiding the C corp structure altogether. While this entity offers the advantages listed above, you may find that the double taxation requirement is just not economically feasible for your business.
However, if you still feel that structuring as a C corp is best for your business, there are ways you can reduce your corporate tax obligations.
While the double taxation requirements of a C corp may have you hesitating to use this structure, there are other benefits and drawbacks to consider.
You should stick to the C corp structure if the following applies:
On the other hand, the double-taxed C corp structure may not be a good fit for your company for these reasons:
How Accracy can help
After learning about the varying taxation requirements of the above business entities, you may be considering switching your business to a different tax structure. This switch may also require a change in how you do your company's bookkeeping and tax filings.
With Accracy, you can rest assured that your business's tax structure transition goes smoothly with our expert bookkeeping team. Even after your business has successfully migrated to the new structure, Bench will ensure that your books are kept accurate and up-to-date. Our tax filing solutions can also give you peace of mind that your corporate taxes are filed correctly and on time.
Deciding on a structure for your small business is an important decision that affects your bookkeeping and taxes. If you are considering the C corp structure for your business, the double taxation obligation can take a toll on your overall bottom line. However, actions like paying salaries instead of dividends and reinvesting profits can help you minimize the corporate tax burden and keep your business on solid financial ground.
We are offering free 1 Month Basic Bookkeeping to all new customers so you can experience Accracy's seemless and professional services.
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