C Corp Double Taxation: Everything You Need to Know
C corp double taxation is one of the few disadvantages of operating a C corporation.3 min read
2. What is Double Taxation?
3. International Double Taxation
4. How to Reduce C Corp Double Taxation
Updated November 25, 2020:
C Corp Double Taxation
C corp double taxation is one of the few disadvantages of operating a C corporation. To understand the concept of double taxation, it is important to understand what a C corporation is and how it functions and operates, particularly concerning tax implications.
What is Double Taxation?
Double taxation refers to paying taxes twice for the same earned income. It usually occurs when income is taxed at both the corporate and personal levels. Unfortunately, the concept of double taxation is a consequence of certain tax legislation. Most people and businesses want to avoid the double taxation problem whenever possible. However, if you want to operate your business as a C corporation, then you will be forced to deal with the double taxation implication that all C corps are faced with.
Concerning C corporations, double taxation means that the company itself is taxed on income. Thereafter, any additional profits leftover that is distributed to shareholders (usually in the form of dividends) are then subject to income tax at the personal level.
If you want to incorporate, but don’t want to deal with the double-taxation issue imposed on C corps, you can elect to operate as an S corporation for federal tax purposes. S corps pass-through the company’s earnings to the shareholders. Therefore, S corps don’t pay corporate income tax. All of the income and losses flow to the shareholders who will then report the profits on their own personal tax return, only up to the amount of capital that each shareholder invested into the company. Losses incurred by the S corp can also be deducted on the shareholder’s personal tax return.
International Double Taxation
For those businesses operating internationally, they are also usually faced with double taxation implications. If income is earned in a country outside of its home country, that income can be taxed in the country in which it was earned, as well as its home country. Sometimes, the costs are so high that it makes it inconceivable to even operate internationally.
To avoid this issue, several countries have signed treaties to avoid the problematic issue, basing the treaties on models provided by the Organization for Economic Cooperation and Development. Such treaties agree to limit double taxation issues on international businesses. This can help establish trade between the two countries.
How to Reduce C Corp Double Taxation
Some ways to reduce C corp double taxation include:
• Retained earnings
• Salary distribution
• Income splitting
• No corporate profit to tax
• Add shareholders to payroll
Retaining earnings is one way to avoid double taxation. By retaining income rather than distributing it to shareholders through dividends, you can avoid double taxation as the shareholders won’t be forced to pay taxes since no distributions will have been made. This is particularly a good idea for corporations that can afford to reinvest the cash into the company to further grow and expand the business.
Salary distribution is another way to reduce double taxation. If you distribute the additional profits from the corporation in the form of income or year-end bonuses, then you can reduce the second layer of double taxation. While the salary or bonus would be taxable to the shareholder, it will also be a deductible business expense for the corporation. This is especially beneficial for companies whose income is mainly derived from operations.
Income splitting is another good way to reduce double taxation. An example of this would be owners withdrawing profits of the corporation to support their lifestyle and then leaving the rest of the money in the corporation. This essentially minimizes the double taxation issue since only a portion of the profits is taken out as salary (which is deductible on the part of the corporation), and leaving the remainder in the corporation for reinvesting. Therefore, as a result, the owner’s gross income and the corporation’s taxable income are reduced.
For some small entities, the distributions made to employees and owners account for all of the company’s income. For that reason, there is no corporate profit to be taxed. Therefore, the corporation is not taxed, and only those owners and shareholders are taxed at the personal rate.
Another way to avoid double taxation is to add shareholders to the payroll so as to offer the additional profit in the company in the form of increased income, as opposed to dividend distribution.
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