Are C Corporations Double Taxed? Detailed Tax Guide
A C corporation is a business structure that is often overlooked by small business owners as a viable option. C corporations have a number of structural advantages over other types of businesses such as sole proprietorships, LLCs and S corporations that they cannot offer. The purpose of this article is to discuss what the benefits of C corporations can be to their owners, as well as the tax advantages associated with them.
What Is a C Corporation?
C-corporations are legal structures for corporations in which the owners, or shareholders, are taxed separately from the corporation. The most common type of corporation, the C corporation, pays corporate income tax. The profits derived from a business are taxed at both the corporate and personal levels; thus, there is a double taxation situation.
C-corporations, or C-corps, are almost always accompanied by the phrase "double taxation". Double taxation elicits such a negative response, but what is it exactly?
What Is Double Taxation?
The term "double taxation" is used in the context of C-corporations that generate profits and distribute them to investors in the form of dividends during the year. In other words, it is double taxation because there is a first tax that a corporation pays on its profits, and a second tax paid by the recipient on dividends.
Corporate profits are subject to a federal income tax rate of 21% in 2022. Individuals pay a top marginal income tax rate of 37% in 2022. Therefore, a dollar subject to double tax could see a maximum total rate of 58% if it were double-taxed in the United States. The fact that double taxation costs quite a bit should not surprise anyone.
For corporate profits to be taxed twice, there are two reasons offered. Corporations are separate legal entities, which allows a tax on corporate profits to be justified. Additionally, dividend taxes are imposed to prevent rich shareholders from avoiding income taxes.
Are C Corporations Double Taxed?
The C-Corporation is double-taxed. C-Corporation profits are taxed after deducting the expense, loss, and any credit and deduction possible. Dividends are distributed to shareholders by C-Corporations after they have paid taxes on their earnings. The dividends are taxable to the individual shareholder.
How To Avoid Double Taxation
For corporations, as well as for shareholders, double taxation is a significant burden. However, it is by no means an unavoidable outcome. Business owners can reduce taxes in general or avoid double taxation corporations altogether by taking the following steps.
Organizing a business as a flow-through or pass-through entity ensures that business profits are taxed only once. Businesses that are organized as pass-through entities receive profits directly from their owners. In doing so, while these benefits are exempt from being taxed at the corporate level, they are subject to personal taxation. Taxes will instead be collected at the owners' individual rates, so c corporation double taxation is avoided.
This strategy may be appropriate for pass-through business entities such as:
Corporate Double Taxation Avoidance Strategies
There are several strategies C corporation owners can adopt in order to reduce or avoid c corp double taxation:
- Retain earnings instead of paying dividends: Corporations that don't distribute their earnings to shareholders, as dividends, are only required to pay taxes once, at the corporate tax rate.
- Dividends may be replaced by salaries: The corporation may instead pay higher salaries to shareholders who work for the company. Corporations deduct salaries as deductible expenses, but employees are taxed at the personal rate. Employees pay income tax at their personal rate, while corporations deduct salaries as deductible expenses.
- Pay family members: If the business allows family members to work for it, their salaries can be paid. Using this method, you can still receive money from the corporation without it having to cover any taxes at all on it first. Family employees are also subject to the same restrictions regarding justification.
- Taking a loan from business: Corporation owners receiving a loan from their company are not subject to income tax. Nevertheless, the IRS may examine the loan to make sure it is not a disguised dividend. The loan may need to be repaid at an interest rate that is reasonable, for example.
- Establish a separate flow-through entity: This second company can be used to lease equipment or property to your C corporation through the use of this process. It is possible for business owners to create LLCs to purchase equipment and lease it back to their corporation. As a result, the LLC generates a flow-through income and the corporation is able to deduct income.
- Tax status elects: Corporate owners can formally request the IRS to treat their corporation as an S corporation for tax purposes. Corporations organized as S corporations enjoy the same liability protection advantages as C corporations, but dividends are distributed directly to shareholders, which avoids double taxation. As a result, S corporations have restrictions regarding the number and type of shareholders, and the classes of stock. Therefore, it may not be possible for every corporation to choose an S corporation.
How To Determine If You Need To Pay Double Taxes
Those who serve on a company's board of directors and who receive dividends personally can choose not to pay taxes on the dividends received. In the end, the business will pay its corporate tax, which leaves them with no tax liability on those gains. Additionally, you can minimize taxes or restructure your business entirely to ensure profits go directly to shareholders.
Taking steps ahead of time can help employees in situations where they may have to pay double taxes on dividends. It is generally possible to benefit from this tax reduction by not selling your investments for a certain period, thus allowing you to enjoy a lower tax rate. Your holdings will be considered "qualified" when you have met these requirements. In general, dividends will qualify for qualifying status if you hold them for at least 60 days following the specific ex-dividend date.
It is possible to get quite confused when it comes to dividend taxes. Before making any final decisions, consider speaking to an advisor or tax professional.