What Is Double Taxation? (And 7 Ways To Avoid It)
The 2017 Tax Cuts and Jobs Act reduced corporate income tax from 35% to 21%. While corporations are enjoying the extra savings, that doesn’t mean they’re not vulnerable to paying high taxes.
There are times when something known as double taxation happens. But what does double taxation mean? And while it sounds unfair, is it really?
You may also think that if you’re vulnerable to being taxed twice, there’s no way to avoid it. But that may not be necessarily true.
We want to help you understand everything about double-taxed income so you and your company won’t have to pay more than necessary. Keep reading to learn more.
What Double Taxation Is
What is double taxation? It’s a tax principle that happens when income taxes are paid twice on the same source of income.
Double taxation only happens with C-corporations. That’s because of their entity structure.
Since a C-corporation is established as a separate entity from its owner and its shareholders, each individual must pay their own income taxes from any profits they generate.
Passed Along Profits are Considered Income by the IRS
When a C-corporation passes along the profits to its shareholders, the IRS recognizes that money as income. That’s because owners and shareholders are separate entities from the company.
As a result, that income must be declared and taxes owed.
Situations Where Double Taxation Can Occur
It can happen when income at both the corporate and personal levels is taxed. What that means is taxes are imposed on both corporate shareholders and corporations.
The corporation gets taxed on its profits (earnings), and then the shareholders get taxed again for the dividends they received for those earnings.
Double taxation can also happen in international trade or investment when the same income is taxed in two different countries. It also occurs with 401k loans.
Owners of Corporations May be Subject to Double Taxation
Double taxation also applies to shareholders who are both employees and owners of a corporation. This is because the owner of a corporation is receiving a salary as an employee. That salary is then required to be taxed at the regular personal income rate.
It can also happen when the owner is also a shareholder. If the corporation pays dividends on the profits, then the owner has to pay tax on those dividends on their personal tax return.
International Double Taxation
International businesses are also often subject to double taxation. The income earned in the country where it was earned is taxed.
Those profits can then be taxed again when it’s repatriated back to the corporation’s home country. If the total tax rate is too high, it can become too expensive for a company to continue doing business internationally.
Based on Models by the OECD
Thankfully, many countries around the globe have signed treaties to avoid double taxation. Often these treaties have been based on models provided by the Organization for Economic Cooperation and Development (OECD).
The nations involved in the treaties agree to limit the taxation amounts for international businesses. These treaties help augment trade between the two countries, while international businesses avoid paying taxes twice.
How Other Businesses are Taxed
Every type of business is taxed differently.
S-corporations have taxes imposed in a similar way to a partnership than a corporation. The profits from an S-corporation is taxed to the owners on their individual income returns.
LLC’s, Partnerships, and Sole Proprietorships
LLC’s, partnerships, and sole proprietorships are pass-through entities. Meaning the IRS considers the income of the business as personal income to the owner.
The owner(s) then are taxed directly and pay taxes on their individual income tax returns. This form of taxation differs from a C-corporation which pays its own taxes.
Is Double Taxation Fair?
Since no one likes being taxed once, many people feel that double taxation is unfair. Those against double taxation feel the government should levy taxes at the corporate or individual level without taxing both.
But some feel double taxation is fair. Those who are in favor of double taxation point out that since the dividend policy is set at a corporate level, if a corporation has concerns that its owners and shareholders will be taxed twice, the corporation shouldn’t make dividend payments.
Older Established C-corporations are More Prone to Double Taxation
Many smaller or less established C-corporations don’t pay dividends to their stockholders. Instead, they put the income (retained earnings) back into the company for growth.
Older, more established C-corporations experience slower growth rates. They don’t need to use that money to grow their company, so they use some of that income as dividends to shareholders.
C-corporations are Separate from its Shareholders
If you consider the corporation and its shareholders as two separate entities. The corporation is only paying tax on its profits, just like the shareholders are only paying tax on the dividend he or she personally received.
Also, if shareholders didn’t have to pay tax on their dividend income, that would be the only type of income that isn’t subject to taxation.
Advantaged Tax Treatment
Also, thanks to varying tax rates and tax credits, if dividends meet specific criteria, it can be classified as “qualified.” Being “qualified” happens when a shareholder or corporate executive buys and holds onto stocks long enough to meet the qualified dividend level.
As a result, that income is subject to advantaged tax treatment. The amount paid then depends on the individual’s tax rate but is either 0%, 15%, or 20%.
For this reason, most corporate executives choose to take shares rather than direct payments.
How to Avoid Paying Double Taxation
If you’re concerned about being subject to double taxation, there are some ways to avoid it.
1. Don’t Pay Dividends
If you’re the CEO or on the board of directors of a C-corporation, refrain from paying out dividends. Instead, let the corporation pay the tax on the income.
But… Watch Out for Penalties
However, you may have to pay a penalty if the company accumulates too much in profits without paying out dividends. Talk to an accountant if you have over $200,000. If the IRS determines that the accumulation of profits is a reasonable amount to meet the needs of the business, you’re fine, otherwise, you may be subject to double taxation.
2. Pay Yourself a Salary
You can also make yourself an employee and pay yourself a salary rather than taking dividends from the stock you hold. Your salary will then be deducted from the C-corporation’s profits as a business expense.
However, to do this, you must justify the salary as reasonable to the IRS, or they may view the money as a disguised dividend. When choosing a salary amount, look at the wages for others in a similar position. You can also determine your salary number by basing it on your own salary history.
But… Salaries are Subject to Other Forms of Taxation
Remember that any wages you do pay to yourself as a salary are subject to the following:
- Federal payroll taxes
- Federal unemployment tax
- State unemployment tax
- Social Security
If you took the dividends, you are not subject to pay any of these taxes.
3. Change Your Business Structure
You can also choose to change the structure of your corporation to one that is more favorable tax-wise. However, keep in mind that C-corporations don’t pay taxes on business income until it’s paid out in dividends.
But other types of business structures do pay tax on all the income earned during the year. Talk to an accountant to see which business structure offers your company the lowest taxes.
If you choose to form an S-corporation instead, you must follow the specific rules and regulations in the state which you file. You can find those rules and regulations listed on the state’s Secretary of State website.
Keep in mind; you don’t have to incorporate your company in the state you live in or even where your business is located. But if you do register your corporation in a different state, you must register to do business in your own state as a foreign corporation.
That could result in more taxes.
Note: Your Company May Not be Eligible to Change Business Structures
You may not even be able to form an S-corporation or another type of business structure. To create an S-corporation, you must meet the following criteria:
- Business must have 100 or fewer shareholders
- Shareholders must be U.S. residents
- Shareholders must be individuals, not corporations or partnerships
- Can only issue one class of stock
Also, if you do elect to be taxed as an S-corporation, you may be subject to built-in gains tax if you sell company assets after you make the switch.
If you do decide to make the switch, talk to an accountant to make sure you fill out all appropriate forms for the IRS. You also need to pay quarterly taxes and create a Schedule K-1 for each shareholder.
4. Form an LLC or Partnership
If you decide to restructure your business as an LLC (limited liability company), you’ll have to come up with a company name that hasn’t already been taken within the state you form the company.
It’s also a good idea to make sure the website domain name (URL) with that same name hasn’t already been used.
Draft an Operating Agreement
If your business is complex, you’ll need to draft an operating agreement that includes provisions that deal with the division of ownership and income among all LLC members. While you usually don’t have to file a copy of your operating agreement with the state, if you have more than one business partner, it’s a smart idea.
You must also register your business with the state and pay all necessary filing taxes.
Get an EIN
You’ll need to contact the IRS to receive an EIN (employer identification number).
The EIN will let you open up a separate bank account(s) in the name of your LLC. You should keep your LLC and personal finances separate.
And if you form an LLC with more than one person, it’s typically taxed as a partnership. You’ll have to fill out Form 1065 if you have a partnership versus an LLC.
5. Hire Family Members
Let your family members take advantage of nepotism. If you’re married or you have kids, you can hire them to work at your company.
However, just like if you pay yourself a salary, you have to pay them a reasonable salary and follow all applicable labor laws.
If you do this, you must be able to prove that you hired family members who are legitimately working for your business.
6. Borrow Money from Your Business
Another solution is to take out a loan from your corporation’s profits. The money you loan yourself isn’t subject to any additional taxes.
However, you must be able to prove that it’s a legitimate loan that you’re paying back at a reasonable interest rate.
And keep in mind that if you borrow large amounts, you may not save any money in the long-term.
7. Lease Your Equipment from an LLC
Besides saving money, there are other advantages to leasing your equipment from a separate LLC.
If you do lease your equipment at fair market value, you’re allowed to deduct those lease payments.
Consult With a Tax Professional
No matter what type of business you’re in, it’s vital to talk to a professional tax accountant to ensure you form the right kind of business and pay the least amount in taxes.
Doing so will help you avoid double taxation as much as possible.
Avoid Potential Problems
It’s also smart to work with a tax attorney, especially if you find yourself in trouble with the IRS. Even if you aren’t, knowing how to avoid potential problems and staying on the right side of the law will make doing business that much easier.
We want to help you keep your business healthy while reducing your tax burden. Contact us to speak with one of our professionals today.
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