What is double taxation and why is it important for my small business?

“Double taxation” refers to the two “levels” of tax that are assessed by the IRS on profits earned by C Corporations–a “C Corporation” simply refers to a corporation that is taxed according to subchapter “C” of the US Tax Code–or other entities that elect to be taxed as C Corporations. The first level of taxation is at the corporate level; these taxes are assessed on the corporation’s profits before the company distributes any dividends to shareholders. The second level of taxation applies at the individual level when the corporation distributes dividends to individual shareholders.

Double Taxation

How to Avoid Double Taxation

Entities that elect to be taxed as C Corporations (or are taxed a C Corporations by default) are subject to double taxation. Businesses that are not subject to double taxation are called “pass-through” entities (or “disregarded entities”), which includes sole proprietors, S-Corporations, Partnerships, and LLCs that do not make the election to be taxed as a C corporation.

For a pass-through entity, there is no tax assessed at the corporate level, and all income generated by the business is attributable to the owners of the entity. The income is “passed through” to the owners. Pass through business entities avoid double taxation by allowing the profits of the company to be taxed on the individual level as ordinary income. That is, pass through entities avoid two “layers” of tax in exchange for a higher tax on the single “layer,” ordinary income.

Example Comparison of C Corporation v. Pass Through

C Corporation

Assume that Bob is starting a Seattle-based business making Seahawks shirts, and that after meeting with his attorney and CPA, he decides to form a C Corporation. In his first year, he manages to make a profit of $100,000 after all expenses. In addition, assume that corporate tax rate is 34%. Bob’s business will pay $34,000 in tax. After paying corporate taxes, his corporation has made a total net profit of $66,000. Now assume that he distributes all net profits to himself in the form of a dividend, and the tax rate applied to Bob’s dividend income is 20%. After paying the second level of tax, that is, the $13,200 tax on his dividend income, the total amount that Bob receives after taxes from the operation of his business is $52,800, and the total amount paid in taxes is $47,200.

Pass-Through

Now assume that Bob is beginning another business based in Bellevue making Sounders T-shirts. This time he decides to create an LLC and does not elect to be taxed as a C Corporation. Because he does not make the election, the LLC is treated as a pass-through entity for tax purposes, and all income from the entity passes through to Bob. In the first year of operating his business, Bob’s business makes $100,000 profit. Since he is the only owner of this business, he distributes all of these profits to himself. Bob’s personal income tax rate is 25%. Since Bob’s business is taxed as a pass-through entity, Bob has a net profit after taxes of $75,000 and a total amount paid in taxes of $25,000.

In this example, Bob made the same profit at the entity level as he did with his Seattle business, but the difference in his choice of taxation for his Bellevue business resulted in a total tax savings of $22,200.

Note that these examples do not take account of non-dividend personal income Bob may have received from the businesses (i.e. wages).

So why would anyone choose to be taxed as a C corporation and pay tax twice?

Retained Earnings by the Business Entity

When using a pass-through entity, the business’s net income is still taxed by the IRS even if those profits are not distributed to the owners. This is often called “phantom taxation.” The earnings are attributed to the owners of the business according to the percentage of the entity that they each own, and the individuals are taxed as if the earnings had been distributed even if that individual did not receive a single dime throughout the year. This can be very problematic, particularly for owners that want to reinvest earnings in their business but that may not be able to come up cash from elsewhere to pay the tax. Many passive owners, e.g. investors, do not want to be taxed on money they don’t actually receive.

In contrast, the earnings of a C Corporation are taxed at the entity level. But if the C Corporation decides to keep the earnings and reinvest or hold for a rainy day, the individual owners are not taxed and, therefore, they do not have to come up with cash.

The earnings that are kept in a C Corporation for business purposes are called “retained earnings.” Retained earnings are not taxed unless and until they are distributed to shareholders, which allows owners to have more flexibility regarding reinvestment and not worry as much about the tax situation of individual shareholders. One caveat is that the IRS can determine that the C Corporation is retaining too many earnings. If the IRS makes this determination, then the C Corporation can be taxed on their retained earnings.

Double Taxation-Double Tax

Double taxation is only one factor to consider when creating your business. The wise advice is not to let the “tax tail” wag the “business dog”.  Instead, consider the long term objectives of the business, the business owners’ ability to sacrifice liquidity to the IRS, and other corporate governance considerations.

If you would like to learn more on double taxation, entity formation, or different types of business entities, please don’t hesitate to contact me today.

Thanks to Jesse Livingston for his assistance drafting and editing this post.

PhotosDonkeyHotey | Flickr

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