Business taxes are necessary for running a business, but sometimes, the rules can feel stacked against you. Double taxation is a particularly frustrating concept: Your company works hard to turn a profit, pays its share of taxes, and then faces another tax bill on those same earnings.
It’s enough to give any business owner, particularly those heading smaller or multi-state operations within the US, a major headache.
However, double taxation isn’t an unbeatable foe. By understanding how it works and knowing your options, you can take back control and protect your hard-earned profits.
How Does Double Taxation Work?
Let’s go over the main mechanics behind double taxation. The crux of the issue lies with C corporations. These businesses are considered separate legal entities for tax purposes.
So, when a company makes a profit, it gets hit with corporate income tax upfront. So far, pretty standard — the business entity contributes its fair share.
The trouble starts when a C corporation distributes a portion of those profits to its shareholders as dividends. These dividend payments become income for the individual shareholders, and that’s where double taxation occurs — at the individual income tax level.
Let’s illustrate this with some numbers. Imagine your company earns $100,000 in profit. The corporate tax rate might take a chunk of that (let’s say 21 percent for simplicity).
You’re left with $79,000. If you distribute some of this as dividends, a shareholder in a high tax bracket could pay additional taxes on that income.
You can see how the same corporate earnings effectively get taxed twice, reducing the bottom line for both your business and its investors. However, that’s not all.
There are other points to be aware of:
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C Corps take the hit: C corporations are the ones primarily affected, although their investors feel the impact as well.
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The pass-through advantage: Businesses structured as sole proprietorships, partnerships, and many LLCs generally sidestep this, as profits pass to the owners for a single round of taxation at their individual rates.
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Dividends matter: Individual dividend taxation can have its own complications, with the potential for more favorable “qualified” dividend status in some cases.
Double taxation is a very real issue. The good news is that awareness is the first step. Now that you understand the core mechanics, we can explore why this matters and, most importantly, the strategies to combat it.
Why Does Double Taxation Matter?
Technically, the argument goes that separate entities are earning the income. First, the corporation, then the individual. However, for smaller businesses especially, this can feel like a technicality designed to squeeze more revenue out of you.
Now, let’s address the elephant in the room. There is a justification for double taxation, and it’s designed to prevent businesses from going down a slippery slope. Think if all corporate profits were only taxed once upon distribution — it may give a pass to the ultra-rich.
On the one hand, double taxation hits businesses (especially smaller ones) and individual investors hard. It can discourage investment and feel like a penalty for success.
On the other hand, there’s a need to prevent it from becoming a massive tax break for taxpayers already at the top. This inherent conflict means managing double taxation is less about right or wrong and more about understanding the rules of the game.
It highlights the importance of strategic business structure and proactive tax planning. For instance, if you run a small but growing company, the C corporation model may not be ideal due to the double tax risk.
Exploring alternatives or taking steps within the C corporation structure to minimize the tax burden becomes essential.
Here’s where things get especially important for American entrepreneurs operating across multiple states: Tax regulations can vary wildly. What triggers double taxation in one state might not in another.
This makes professional advice from a tax expert doubly important. They can guide you to maximize your profits within the constraints of our intricate tax system.
What Are Some Strategies To Avoid Double Taxation?
Let’s be clear: There’s no way to make double taxation disappear entirely (unless you’re not a C corporation). However, with smart planning, you can significantly reduce its impact on your bottom line.
For C Corporations
C Corporations are inherently vulnerable to double taxation, so the focus here is mitigation. We recommend working closely with a tax professional, as this is not tax advice. Let’s break down the key options:
Rethink Your Dividends
Instead of distributing profits as dividends, reinvest those earnings back into the company. This keeps more money within the business, which is taxable only at the corporate level, fueling growth and potentially increasing future earning capacity.
Get Paid a Salary
If you or other shareholders work for the company, you can take on salaries. Salaries are tax deductions for the corporation, lowering its taxable income. Of course, your salary becomes personal income subject to taxation, but with careful planning, this can be strategically balanced with the business benefit.
Setting Up a Separate Entity
Creating a separate pass-through entity (like an LLC) under your company’s umbrella can work. You can lease equipment or property to your C corporation through this entity. The LLC’s income flows through to you, is taxed once, and becomes a deductible expense for the corporation.
The S Corp Option
Electing S corporation status means your business income passes through to shareholders, taxed only at the individual level. However, S corps have restrictions on the number and types of shareholders, which may not fit all businesses.
For Businesses Generally
If double taxation is a major concern, the most powerful strategy is choosing the right business structure upfront.
Pass-through entities offer significant advantages in this regard:
Sole Proprietorships
The simplest structure: Profits flow directly to you, the owner, for a single round of taxation on your individual return. This model favors ease of setup, but be mindful that you are personally liable for the business’s debts and obligations.
Partnerships
Similar to sole proprietorships, but with multiple owners sharing the profits (and tax liability). Partnerships offer the potential to combine resources and expertise, but careful consideration must go into formalizing the partnership agreement to avoid disputes.
LLCs
These offer flexibility. You can choose to be taxed as a sole proprietor/partnership or as a corporation. With an LLC, owners gain added liability protection, separating personal assets from business debts, making them a popular choice for small businesses.
S Corporations
As mentioned earlier, an S corp can eliminate double taxation, but its restrictions mean it may not be the perfect fit for all companies. These limitations include caps on the number of stockholders and restrictions on the types of stock that can be issued.
Tax laws are notoriously complex, and what’s best for one business may not be for another. Seeking advice from a tax professional is essential — consider it an investment in maximizing your profits and avoiding costly mistakes.
What Does Double Taxation Look Like for International Business?
Expanding your business internationally is exciting. However, the tax arena gets even more treacherous, as your profits could face taxation in the country in which you earned them (foreign income) and then again when you bring those earnings back to your home country.
Thankfully, many countries have tax treaties designed specifically to prevent this. These treaties outline which country gets to tax what and often offer mechanisms like foreign tax credits. A foreign tax credit can offset what you owe on your home country’s tax return, lessening the burden.
International tax authorities are a whole other animal for U.S. citizens. Seeking expert advice from someone specializing in this area is absolutely essential for any business with international operations or income sources.
How To Tell If You’re at Risk for Double Taxation
Knowing whether double taxation is a consideration for your company requires careful planning.
Here’s a breakdown of different groups within the business:
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Business Structure: Is your company a C corporation? If so, double taxation is always a possibility.
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Income Sources: Are profits derived from both domestic and foreign operations? This opens up the potential for international double taxation.
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Dividend Policies: Does the company distribute significant dividends? This is where the double-tax hit on shareholders becomes relevant.
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Employees: If you receive dividends as part of your compensation, the concept of “qualified” dividends matters. These dividends are taxed at a potentially lower rate if held for a certain period. This is where discussing with a tax professional is key, as there are specific rules and timelines to qualify.
The bottom line is that double taxation isn’t something you guess at. Be proactive. If any of the factors above apply to your business, it’s time to enlist professional guidance from a knowledgeable tax advisor.
Let Mosey Simplify Your State and Local Tax Obligations
This is especially true if you’re dealing with multiple states or countries — getting the structure and strategy right from the outset can save you massive headaches and money down the line.
The concept of double taxation can indeed be quite formidable. Understanding the mechanics, knowing your options, and getting proactive about tax planning can make all the difference.
Worrying about tax compliance, both for state and local tax, shouldn’t distract you from growing your business. Let Mosey handle filing taxes and deadlines for your business so you can focus on building your success.
Book a demo and see how we can simplify your tax obligations.
