What is Double Taxation?
You may have heard the term "double taxation" and wondered what it means. Corporate shareholders often complain that they are being "double taxed." But what really is double taxation and how unfair is it?
What is Double Taxation?
Double taxation is a term used to describe the way taxes are imposed on corporate shareholders and on corporations. The corporation is taxed on its earnings (profits), and the shareholders are taxed again on the dividends they receive from those earnings.
Another description of double taxation applies to shareholders who are also employees and owners of the corporation:
- The "owner" of the corporation receives a salary as an employee. This salary is taxed at the regular personal income tax rate.
- In addition, the owner is also a shareholder. If the corporation pays dividends on the profits of the corporation, the owner must pay the tax on those dividends on his/her personal tax return.
Dividends are taxed at the shareholder's personal tax rate,
Notice that we're only talking about corporations having to deal with the double taxation issue. Other types of businesses don't have this problem.
Do S Corporations Have Double Taxation?
S corporations are a specific kind of corporation that is taxed more like a partnership than a corporation. S corporation profits are taxed to the owners on their individual income tax returns. This article about how S corporations are taxed might help explain.
Do LLC's, Partnerships, and Sole Proprietors Have Double Taxation?
LLC's, partnerships, and sole proprietors are what is called "pass-through entities, meaning that the income of the business is passed through to the owners, who pay the taxes on their individual income tax returns. So, the owners of these businesses are taxed directly, unlike a corporation that pays its own taxes.
Partnerships and multiple-member LLC's (taxed as partnerships) file a partnership tax return, but this is only an information return for the purpose of determining the net income of the business. This net income is passed through to the owners. Sole proprietors and single-member LLCs file a business tax report on Schedule C and the income is included in the owner's personal return.
Is Double Taxation Fair?
Is it really double taxation when two different entities (the corporation and the shareholders) are being taxed? Remember, the corporation itself pays tax on its profits and dividends are taxed to the individual shareholders.
If shareholders didn't pay tax on their dividend income, it would be the only type of income that isn't subject to tax. This seems regressive (weighted more favorably toward higher income).
What About Taxes on Dividends?
Shareholders of corporations, including individual investors and corporate executives, pay taxes on dividends. Ordinary dividends are taxed at the individual owner's tax rate. But dividends held for a longer time (according to IRS rules) are considered "qualified." These qualified dividends are taxed at the lower capital gains tax rate of 15% if the owner has an income level under $425,800.
Buying and holding stocks long enough to meet the qualified dividend level can give you a lower tax rate for those dividends. That's why many corporate executives take shares instead of direct payments.
Growth Corporations vs. Income Corporations
Here's another way to look at dividends: Most small corporations and new corporations don't pay dividends. They put the income (called retained earnings) back into the company for growth rather than paying dividends to shareholders.
It's only the older, more established corporations have slower growth, and they use some of their income as dividends to shareholders.
How Can I Avoid Double Taxation?
If you are on the board of directors or CEO of a corporation, don't pay dividends. Let the corporation pay the tax on the income of the business. Make yourself an employee and pay income tax on your earnings from employment.
The other way to avoid double taxation is to structure your corporation as something other than a corporation. The tax on the net income of the business is passed through to the owners. BUT, corporations don't pay taxes on business income (called retained earnings) until it's paid out in dividends, while other business types pay tax on all the income from a business during the year, so you have to decide which will give you the lower tax.
Getting Help with Business Taxes
The decision of which business type will give you lower business taxes is one you need to discuss with your advisors, both a tax attorney and a CPA. Every business is unique and the tax rules change frequently. Don't try to do this yourself.