What Is Double Taxation and How to Avoid It? (2024)

× Nancy Mann Jackson is an award-winning journalist and content marketing writer who specializes in writing about finance, real estate, healthcare, small business andhuman resources. Her work appears inpublications including CNBC.com, Fortune.com, Entrepreneur, Working Mother, CNNMoney.com, and DailyWorth,and she writes for brands including HSBC Bank, Capital One, Glassdoor, Oracle, ADP, Cintas, Staples,American Express, Acorns, Hospital Corporation of America and a number of others.

The most important decision you make when you start your business — outside of setting the product or service you’ll be selling — might be the corporate business structure you choose. You could form a sole proprietorship, an LLC, an S corporation, or a C corporation. But if you form as a C corp, you’ll have to watch out for double taxation.

So what is double taxation, and how could it affect your business and your bottom line?

What Is Double Taxation?

Double taxation is precisely what it sounds like — being taxed twice on the same source of income. Unlike LLCs, sole proprietors, and S corps, which don’t pay business taxes directly, C corps must pay business taxes. Let’s break it down:

  1. C Corp Taxes: C cop files its income taxes, subtracting expenses and losses. Then, it pays taxes on the remaining profits. The current corporate tax rate is set at 21% by the IRS.
  2. Shareholder Taxes: If a shareholder or owner takes a salary or wages from a C corps’ corporate earnings, they must also pay personal income taxes on those earnings.

So, if you own a C corp, your earnings will be taxed twice—first on the corporate earnings, then on the dividends or wages you earn from the business.

Example

Let’s imagine that your C corp company will make $100,000 in profit this year. The corporate tax rate for 2024 is 21%, according to the Tax Foundation, so your business will have to pay $21,000 in corporate taxes to the IRS. You and your shareholders will receive dividends from the rest of the $79,000, but you’ll each have to pay personal income taxes on those dividends. And because you’re the owner, you’ll pay personal income taxes on the salary you draw.

How to Avoid Double Taxation

C corps can’t escape this tax maze entirely, but they can adjust their strategies:

  • Retaining corporate earnings. You can avoid double taxation by keeping profits in the business rather than distributing it to shareholders as dividends. If shareholders don’t receive dividends, they’re not taxed on them, so the profits are only taxed at the corporate rate. If you and your shareholders rely on company profit for income, retaining corporate earnings probably isn’t a good idea. But if you can afford to reinvest the cash, you could grow your business.
  • Pay salaries instead of dividends. You can distribute profit as salaries or bonuses instead of as dividends. Employees will have to pay personal taxes on any salaries or bonuses they earn, but they’ll be deductible expenses for your business.
  • Split income. Income splitting is a strategy in which a business owner withdraws from the corporate profit what they need to support their lifestyle but leaves the rest of the profits in the corporation. Because progressive tax brackets affect C corps and individuals, income splitting can minimize double taxation. By taking a tax-deductible salary and leaving the rest of the profit for reinvestment, you reduce your personal gross income and the business’s taxable income.

Double taxation can seem like a penalty for C corp owners, but by incorporating these strategies, business owners can take advantage of the C corp structure while minimizing the effects of double taxation.

Despite the possibility of double taxation, some may still choose C corporation for the following advantages:

  • Limited liability and separate legal identity: C corps provides limited liability for their owners. Shareholders are not personally liable for the corporation’s debts. The corporation has a separate legal identity, meaning it exists independently from its owners. This separation shields shareholders from personal financial risks.
  • Tax advantages for smaller business owners: Unlike sole proprietors or partnerships, C corps don’t pay self-employment taxes on profits. C corps have more flexibility with deductions, salaries, and dividend distributions.
  • Attractive for investors: Investors often prefer C corps due to their well-established legal precedents and widespread acceptance by venture capitalists.

The Bottom Line

While double taxation is a big consideration, the C corp structure offers benefits– especially for companies aiming for aggressive growth. One could argue that regardless of double taxation, C corps provides many advantages for large and small business owners.

Tags: Small Business Resources, Taxes

What Is Double Taxation and How to Avoid It? (2024)

FAQs

What is double taxation and how do you avoid it? ›

You can avoid double taxation by keeping profits in the business rather than distributing it to shareholders as dividends. If shareholders don't receive dividends, they're not taxed on them, so the profits are only taxed at the corporate rate.

What is double taxation group of answer choices? ›

Double taxation refers to income tax being paid twice on the same source of income. This can occur when income is taxed at both the corporate level and the personal level, as in the case of stock dividends. Double taxation also refers to the same income being taxed by two different countries.

What is double taxation quizlet? ›

Double taxation means that​ the: corporation pays taxes on its earnings and the shareholders pay taxes on the dividends received from the corporation.

How can a US citizen avoid double taxation? ›

Of all the options for avoiding US double taxation, the most reliable is the Foreign Tax Credit. In fact, this credit was instituted for the sole purpose of warding off double taxation for Americans living abroad.

How can a business avoid double taxation? ›

Two business structures are often preferred for small businesses since they avoid this double taxation burden. These are an LLC and an S Corporation. With these business structures, the company is taxed more like a Sole Proprietorship or a Partnership than as a separate entity, like the C Corporation.

What does double taxation mean simple? ›

Double taxation is when taxes are paid twice on the same dollar of income, regardless of whether that's corporate or individual income.

What are examples of double taxation? ›

Most commonly, double taxation happens when a company earns a profit in the form of dividends. The company pays the taxes on its annual profits first. Then, after the company pays its dividends to shareholders, shareholders pay a second tax.

What is an example of a double taxation problem? ›

An example of this is the case where both city and county have code enforcement services, but the county provides code enforcement almost exclusively in the unincorporated area - even though funds to support the county code enforcement come from property taxes which are paid by county residents inside as well as ...

Why is double taxation bad? ›

Opponents of double taxation on corporate earnings contend that the practice is both unfair and inefficient, since it treats corporate income differently than other forms of income and encourages companies to finance themselves with debt, which is tax deductible, and to retain profits rather than pass them on to ...

What is double taxation a disadvantage of quizlet? ›

A disadvantage of corporations is that they are subject to double-taxation, which means that a corporation is taxed on its net income and, when the same income is distributed to shareholders in the form of dividends, is taxed again on shareholders' personal tax returns.

Which of the following is subject to double taxation quizlet? ›

Double taxation applies to corporations.

Which type of income is subject to double taxation quizlet? ›

The income of a C corporation is subject to double taxation. The tax attributes of income and expense items of a C corporation pass through the corporate entity to the shareholders.

What is double taxation and how does it work? ›

Most commonly, double taxation happens when a company earns a profit in the form of dividends. The company pays the taxes on its annual profits first. Then, after the company pays its dividends to shareholders, shareholders pay a second tax.

What type of business avoids double taxation? ›

On the special type of corporation of interest to small businesses is the Subchapter S corporation. This type of corporation avoids double taxation by having its income taxed to the shareholders as if the corporation were a partnership.

How can LLC avoid double taxation? ›

Unlike C corporations, LLCs and sole proprietors are legally considered pass-through entities. The structure means their earnings go directly to their owners, who pay their taxes through their personal income tax. Another way you can avoid double taxation is by adopting the S corporation structure.

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