Do you want to know the forms of business ownership that cannot be subjected to double taxation? If YES, here are 7 smart ways you can avoid double taxation.
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What is Double Taxation?
Double taxation is a situation that affects C corporations when business profits are taxed at both the corporate and personal levels. The corporation is expected to pay income tax at the corporate rate before any profits can be paid to shareholders.
Then any profits that are distributed to shareholders through dividends are also subject to income tax again at the recipient’s individual rate. This simply entails that the corporate profits are subject to income taxes twice.
What Form of Business Ownership Can Be Subjected to Double Taxation?
Double taxation does not affect S corporations, which are able to “pass through” earnings directly to shareholders without the intermediate step of paying dividends. Additionally, many smaller corporations are able to avoid double taxation by distributing earnings to employee/shareholders as wages. Still, double taxation has long been subject to criticism from accountants, lawyers, and economists.
LLC’s, partnerships, and sole proprietors are “pass – through” entities as well. Business income is passed through to their owners who pay taxes on their individual income tax returns. The owners of these businesses are taxed directly, unlike a corporation that pays its own taxes.
Partnerships and multiple – member LLCs that are taxed as partnerships must file partnership tax returns, but this is only an informational return. It simply reports the net income of the business to the IRS, and this net income is passed through to the owners and should appear as taxable income on their returns. Sole proprietors and single – member LLCs file their business tax reports on Schedule C and the income is included in their owner’s personal returns.
Critics of double taxation have always preferred to integrate the corporate and personal tax systems, maintaining that taxes should not affect business and investment decisions.
These experts believe that double taxation places corporations at a disadvantage in comparison with unincorporated businesses, influences corporations to use debt financing rather than equity financing (because interest payments can be deducted and dividend payments cannot), and provides incentives for corporations to retain earnings rather than distributing them to shareholders.
In addition, critics of the current corporate taxation system argue that integration would simplify the tax code significantly. Nonetheless, this double taxation makes C corporations the highest – taxed form of business.
7 Ways to Avoid Double Taxation
If you are worried about being subject to double taxation, there are some ways to avoid it.
1. Don’t Pay Dividends
As the CEO or on the board of directors of a C – corporation, it is advisable you refrain from paying out dividends. Instead, let the corporation pay the tax on the income. Nonetheless, you may have to pay a penalty if the company accumulates too much in profits without paying out dividends.
It is very pertinent you talk to an accountant if you have over $200,000. If the IRS acknowledges that the accumulation of profits is a reasonable amount to meet the needs of the business, you are fine; otherwise, you may be subject to double taxation.
2. Pay Yourself a Salary
As an officer/employee of the corporation, you are allowed to take a salary. While you may have to pay taxes at a higher personal income tax rate, have it in mind that your salary is deductible to the corporation. Therefore, you will actually be subject to less tax overall. But to take a salary, you must justify your role in the business. You must be considered “hands on” and be a crucial part of the day – to – day business operations.
If the IRS does not feel that you pay an important role, then there is a good possibility they could disallow your salary, consider it a dividend and subject the funds to double taxation. If you aren’t currently working hard in the business, but still dedicated the blood, sweat and tears to building the business (all while being underpaid), then this might also help substantiate a higher wage.
3. Change Your Business Structure
To avoid double taxation, you can also choose to change the structure of your corporation to one that is more favourable tax – wise. However, have it in mind that C – corporations don’t pay taxes on business income until it is paid out in dividends. But other types of business structures do pay tax on all the income earned during the year. It is still advisable you talk to an accountant to see which business structure offers your company the lowest taxes.
If you choose to form an S – corporation instead, you are expected follow the specific rules and regulations in the state which you file. You can find those rules and regulations listed on the state’s Secretary of State Website. Do not forget that you don’t have to incorporate your company in the state you live in or even where your business is located. But if you do register your corporation in a different state, you must register to do business in your own state as a foreign corporation.
Also, if you decide to restructure your business as an LLC (limited liability Company), you’ll have to come up with a company name that hasn’t already been taken within the state you form the company. It is also a good idea to make sure the website domain name (URL) with that same name hasn’t already been used.
You will also need to draft an operating agreement that includes provisions that deal with the division of ownership and income among all LLC members. While you usually don’t have to file a copy of your operating agreement with the state, if you have more than one business partner, it is a smart idea. You must also register your business with the state and pay all necessary filing taxes.
5. Hire Family Members
To avoid double taxation, you can let your family members take advantage of nepotism. If you are married or you have kids, you can hire them to work at your company. However, just like if you pay yourself a salary, you have to pay them a reasonable salary and follow all applicable labour laws. Howbeit, you must be able to prove that you hired family members who are legitimately working for your business.
6. Borrow Money from Your Business
Luckily, there are not too many tax consequences on corporate loans to shareholders. Moreover, the first $10,000 is completely free from taxes consequences and/or interest requirements. This is called a “de minimus exception.”
If you are borrowing over $10,000 in the period of a year, and are paying little or no interest to the corporation, note that the IRS will classify the interest that you are not paying as income to you. They determine the interest rate you should be subject to by the Applicable Federal Rate (AFR).
Howbeit, if the AFR is 4 percent, and you took out an interest – free loan of $100,000, then you will be required to pay taxes on the $4,000 that you should be paying in interest. It may be confusing but it is a great way to get large amounts of cash without a huge tax burden.
Also, if you are buying a home and wish for your corporation cash – cow to finance the purchase, then you are in luck. Especially since you can deduct the interest on your home, your corporation can give you an interest free loan and you will be free from paying any taxes. In other words, your Corporation can finance the purchase of your home without triggering a taxable event. This is called “phantom interest”.
If you have assets that the company can use for business purposes, you are in a great position! Have it in mind that leasing assets to your corporation is a generally accepted business practice and is a very legitimate way to transfer money to yourself without having an overwhelming tax burden.
Note there are three types of items that you can lease to your company: real estate, equipment and employees. The first two are pretty direct, but there’s no doubt that the last item on that list may sound somewhat confusing.
For instance, if you are like most corporations, you have employees – and the astronomical costs associated with them, including payroll taxes, benefits, hiring costs, training costs, firing costs, etc. A good approach is to put all of these H.R. activities into a separate LLC that you control.
Then this LLC leases the employees to your operating company at the rate of all costs, plus some. Your LLC charges your corporation once per month and the funds are transferred. Note that the leasing of employees is a deductible expense; therefore your corporation can deduct all monies paid to your LLC.
Additionally, your LLC can deduct these expenses against its income, effectively allowing the same expenses to be deducted twice. The money that remains in the LLC after these expenses have been paid passes through to you as income – which is only taxed once, at the personal level. You have effectively found a legal and legitimate way to avoid double taxation.
Irrespective of what type of business you indulge in, it is very important to talk to a professional tax accountant to ensure you form the right kind of business and pay the least amount in taxes. Note that doing so will help you avoid double taxation as much as possible.
It is also necessary to work with a tax attorney, especially if you find yourself in trouble with the IRS. Even if you aren’t, knowing how to avoid potential problems and staying on the right side of the law will make doing business that much easier.