Corporations have different rules and responsibilities than other business structures. And if you own a corporation or are a shareholder of one, you should know what double taxation is.
Unlike other types of business structures, corporations are subject to double taxes. Read on to get the answer to what is double taxation and quiz yourself on double taxation information.
What is double taxation?
Double taxation is when you pay income taxes twice on the same source of income. In the case of businesses, double taxation means a corporation is taxed at both the personal and business levels.
Businesses that have double-taxed income include:
- Corporations (C Corps)
- LLCs that elect to be treated as corporations
Other types of business structures, like S corporations or LLCs, can avoid double tax. How you ask? These other business structures have something called pass-through taxation.
With pass-through taxation, income is only taxed once. Pass-through taxation is when the taxes “pass through” the business onto the owners or individuals instead.
Business structures that typically have pass-through taxation are:
- Sole proprietorships
- Partnerships
- Limited liability companies (LLC)
- S corporations
How double taxation works
For corporations, the company is taxed as a business entity and each shareholder’s personal income is also taxed.
Double taxation comes into play because corporations are considered separate legal entities from their shareholders.
Corporations pay taxes on their annual earnings. When a corporation pays out dividends to shareholders, the dividends also have tax liabilities. Shareholders who receive any dividends must pay taxes on them. Hence, double taxation.
Corporations don’t pay taxes on business income (retained earnings) until it’s paid out in dividends to shareholders.
Feel lost about corporate double taxation? Use the handy flow chart below:
Corporation ⇒ Pay Income Tax at Corporate Level
Shareholders of Corporation ⇒ Receive Dividends ⇒ Pay Income Tax on Dividends
Avoiding double taxation
So, how can you avoid double taxation at your business? There are a few things you can do to avoid being double-taxed, including:
- Not structuring your business as a corporation
- Having employees be shareholders (smaller corporations)
- Adding shareholders to payroll as members of the board of directors (larger corporations)
You can avoid double taxation by structuring your business as a sole proprietorship, partnership, LLC, or S Corp. Again, other business structures have pass-through taxation that allows you to avoid being double-taxed.
You can steer clear of double taxation if you make yourself, owners, or other shareholders employees of the corporation. Employees pay income tax on their earnings instead.
To avoid double taxation altogether, consider not distributing dividends. You can choose another payment strategy (e.g., employee compensation). You could also put the income back into the company rather than paying out dividends.
Double taxation pop quiz
Double taxation can be confusing. Test your knowledge on double taxation below. And remember, no cheating!
1. Who is responsible for paying income taxes on dividends?
A. Owners
B. Shareholders
C. The corporation
2. Which business structure is typically subject to double taxation?
A. S Corp
B. C Corp
C. Partnership
3. With double taxation, corporations are taxed on a:
A. Personal level
B. Business level
C. Both of the above
Answers: B., B., C.
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This article is updated from its original publication date of September 19, 2019.
This is not intended as legal advice; for more information, please click here.
