The term “double taxation” you might have come across many times and you had no idea what it was, or maybe you had a slight idea about it. Moreover, you might have heard a lot of corporate shareholders who often tend to complain a lot of about being “double taxed.” But what exactly is double taxation on a corporation and why are business people complaining about it or trying to avoid it?
What is Double Taxation?
From the term, it is understood that the taxation placed on a corporation is double. It describes the method in which the taxes are imposed on the corporations and the corporate shareholders. There are two ways in which double taxation occurs:
At first, the corporation is taxed on the profits that the corporation earns. Then, the shareholders are again taxed on their dividends that are obtained from the earnings of the same corporation. In short, the shareholders have to undergo the process of paying the taxes twice, leaving them with little from the profits they have earned from the business.
The other description of double taxation on a corporation applies to those shareholders who are also the owners and the employees of the corporation. Since the owner is an employee, he/she gets a salary which is then taxed at the standard personal income tax rate.
Additionally, the owner of the corporation is also the shareholder. And in case the corporation also pays the dividends that are on the profits of the business, the owner would also have to pay tax on those dividends on her/his personal tax return.
Note: We are only speaking about the corporation that undergoes the double taxation issues, while the other business types do not suffer from such an issue.
Have more questions in your mind? The next part would answer some of the main questions in your mind.
Do C Corporations Have Double Taxation?
The double taxation on a corporation affects C Corporations the most, where the profits of the business are taxed at both the personal and the corporate levels separately. Before any profits can be divided among the shareholders, the corporation would have to pay taxes on the income it gets at the corporate rate.
After that, when the profits are divided among the shareholders, the recipient would be taxed again at the personal income tax rate. In this way, double taxation on a C corporation takes place.
Do Sole Proprietors, Partnerships, and LLCs Have Double Taxation?
The sole proprietors, partnerships, and LLCs are known as the “pass-through” entities. This means that the earnings of the company are passed through the owners. And then the owners pay the taxes for this in their individual income tax returns. In short, the business owners are taxed directly for their company in this case.
Do S Corps Have Double Taxation?
The S Corporations are usually taxed just like a partnership and not like the corporations, which means that it is taxed as a pass-through entity. This means that it does not suffer from double taxation, unlike the C corporation where the shareholders, as well as the business profits, are taxed.
In short, if you open an S Corporation, you would not have to pay the taxes for the profits earned by the business. Instead, all the loss or the profit is passed to the stockholders, and they are the ones who report the profit or loss on their personal tax returns. In this case, if you are the only person who is the shareholder and the owner, you would have to pay taxes just once through your personal tax return.
Is Double Taxation Fair?
It has always been a discussion and still is a big debate about the fairness of taxing the corporation along with the taxing of the dividends. The question that many have put up is that – is it even double taxation on a corporation when there are two distinct entities (the shareholders and the corporations) who are being taxed?
It must be remembered and understood that it is the corporation that pays the taxes on the profit it earns. And when it comes to the individual shareholders, it is the dividends that are taxed when they are given the profits (also known as their income).
There are thoughts that if the shareholders do not pay the tax on the dividend income, then this type of income would be the only one that is not subjected to taxes. And this seems regressive, which means that it is weighted more generously towards the people with a higher income.
Income Corporations vs. Growth Corporations
Another method on how to look at the dividends are – A lot of the new corporations and small corporations do not pay dividends. These owners prefer to put the profit also known as the retained earnings back into the business to help it grow, instead of paying the shareholders with dividends. Here, double taxation on a corporation doesn’t take place and these type of corporations are called growth corporations.
And the corporations that are old and well-established do not need to use a lot of the profits to grow (due to the slower rate of growth in this case) or choose not to. Instead, they pay the dividends to the shareholders instead. These type of corporations are called income corporations.
How Can I Avoid Double Taxation?
This is very simple. In case you are the CEO or one of the board of directors of the corporation, do not pay the dividends. Allow the corporation to give the payment of the taxes on the profit of the company. In short, make yourself an employee in the corporation and give the payment of income tax on your earnings from the employment.
The double taxation on a corporation depends entirely on the type of entity your choose to open and how you want to manage everything as you pay the taxes to the government at the same time. Choose smartly!