While death and taxes may both be certain, taxation is the only one of the two that can happen twice. If you own a business, the last thing you want is to get taxed on your income more than once. Double taxation occurs when a corporation pays taxes on its profits and then its shareholders pay personal taxes on dividendsor capital gains received from the corporation. A financial advisorcan answer questions about double taxation and help optimize your financial plan to lower your tax liability.
What Is Double Taxation?
Double taxation happens when income tax gets levied twice on the same income. So if you’re a shareholder or owner of a corporation, then you may face double taxation because your income will come from corporate earnings that were already taxed, and you will also pay taxes on them.
The same happens to individual investors who pay taxes on dividends, which are a share of a corporation’s earnings. Because the corporation has already paid taxes on those same earnings, it can also face double taxation. And, if you have income in a foreign country, you may also get taxed twice for the same income in that country and the U.S., depending on the circ*mstances.
Double taxation can happen in C corporations, where owners or shareholders get taxed separately. Other businesses pass income down to individuals, for them to pay personal tax rates that are levied once.
In 2022, the federal income tax rate on corporate profits was 21%. But as of 2023, the Inflation Reduction Act created theCorporate Alternative Minimum Tax (CAMT), which imposes a 15% minimum taxon large corporations. This applies specifically to corporationswith an average annual financial statement income of over $1 billion.
Comparatively, the top marginal individual tax rate for 2023 is 37%. So if a corporation pays the 15% CAMT, and that income gets double-taxed, the combined rate for an individual taxpayer in the top bracket could be 52%.
There are two justifications offered for taxing corporate profits twice. First, the tax on corporate profits is seen as justified because businesses organized as corporations are separate legal entities. Second, levying individual taxes on dividends is seen as necessary to keep wealthy shareholders from paying no income taxes on their gains.
The burden of double taxation is common and significant for corporations and shareholders alike. However, it’s not an inevitable outcome by any means. There are several ways business owners can avoid double taxation altogether or reduce taxes in general.
Why Double Taxation Matters
The obvious reason that people debate double taxation is that the same money is being earned once but taxed twice. However, there are two different entities – typically the business and the individual – that are earning the same money separately. Many argue that the tax structure is just because the individual is earning money from the business entity and the business entity is earning money from its customer.
So, technically, while the money is being taxed twice it is only being taxed when it is earned by a new person or entity. Without double taxation, many argue, that individuals could own large amounts of stock in corporations and live off of their dividends without ever paying taxes on what they are individually earning. Corporations can avoid double taxation by electing not to pay dividends.
Strategies for Avoiding Corporate Double Taxation
As referenced earlier, C corporations are uniquely the only business type that experiences double taxation. While the corporation pays taxes once itself, double taxation happens when dividends paid to shareholders get taxed at the shareholders’ individual rates after they’ve already been taxed at the corporate level.
One way to ensure that business profits are only taxed once is to organize the business as a “flow-through” or “pass-through” entity. When a business is organized as a pass-through entity, profits flow directly to the owner or owners. In turn, these are not taxed at the corporate level and again at the personal level. Instead, the owners will pay taxes at their personal rate, but double taxation is avoided.
Some examples of pass-through business entities that can adopt this strategy include:
- Sole proprietorships
- Partnerships
- Limited liability companies (LLCs)
- S corporations
Owners of C corporations who wish to reduce or avoid double taxation have several strategies they can follow, which include:
- Retain earnings: If the corporation doesn’t distribute earnings as dividends to shareholders, earnings are only taxed once, at the corporate rate.
- Pay salaries instead of dividends: Shareholders who work for the corporation may be paid higher salaries instead of dividends. Salaries are taxed at the personal rate but are deductible expenses for the corporation. Salaries have to be justifiable to the IRS, however.
- Employ family: Family members can receive salaries for working for the business. This is another way to take money from the corporation without the corporation having to pay taxes on it first. The same restrictions about justification apply to family employee salaries.
- Borrow from the business: If a corporation owner takes a loan from the corporation, it’s not treated as a taxable dividend. The IRS may inspect the transaction to ensure that the loan is not a disguised dividend, however. For instance, this may require that the loan is being paid back at a reasonable interest rate.
- Set up a separate flow-through business: By using this process, you can use this second businessto lease equipment or property to the C corporation. A business owner can create an LLC that purchases equipment and leases it back to the corporation. This creates flow-through income for the LLC and a deduction for the corporation.
- Elect S corporation tax status: Once a corporation has been created, the owners can ask the IRS to treat it as an S corporation for tax purposes. S corporations have the same liability-limiting attractions as C corporations, but their profits flow directly to shareholders, avoiding double taxation. S corporations are restricted as to the number and type of shareholders and classes of stock, however. So, an S corporation election may not be an option for all corporations.
Double Taxation for International Businesses
Businesses that invest and do business internationally may also experience double taxation. This can happen when profits generated in one country are taxed there and then again by their home country. Again, this sort of double taxation doesn’t have to happen. Many countries have signed mutual treaties and instituted tax credits to limit this sort of double taxation in the interest of stimulating international investment and trade.
How to Determine If You’ll Need to Pay Double Taxes
CEOs and members of the board of directors of a business can personally choose not to pay taxes on any dividends they receive. Instead, the business will pay its corporate tax, leaving those gains tax-free for them. In addition, you can also use the strategies above to minimize taxes or change the structure of your business altogether to ensure profits go right to ownership.
If you’re an employee of a business where you may encounter double taxes on your dividends, there are some planning steps you can take ahead of time. In general, these benefits can be earned by not selling your holdings for a specific amount of time, leaving you with a more favorable tax rate. By meeting these requirements, your holdings will garner the title of “qualified.” You can generally reach qualified status for dividends by holding them for at least 60 days of the 121-day period that starts 60 days past their specificex-dividend date.
The rules surrounding dividend taxes can get quite complex. You may want to speak with a financial advisor or tax professional before making any final decisions.
Bottom Line
Tax planning should be an integral part of your business strategy. That goes for pass-through entities and C corporations. Taking a strategic approach to your business structure – who you employ, the extent to which you lease equipment or space and compensation, including dividends, can result in a substantial boost to the profit of your business.
Tips for Small Business Taxes
- Consider talking to a financial advisor about your small business and double taxation.Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Are you potentially looking to sell your small business? If so, check out SmartAsset’s guide to the taxes surrounding a small business sale.
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