Tax season is one of the most complex and frustrating times of year for businesses of all sizes. Making sure that your taxes are filed in time is vital, and there are a wide variety of areas that can cause complications.
One of the most significant and controversial is the concept of double taxation. If you have heard of the term recently, you may be wondering if your business is likely to be affected by it. Nobody wants to be taxed twice, so understanding just what double taxation is and how you can reduce your exposure to it is essential. This guide will explain what double tax is, who is affected, and potential ways that you can avoid it.
Double taxation is the term used for describing one of the ways that corporations and their shareholders are taxed. The reason that it is called a double tax is that not only is the corporation itself taxed, but the shareholders are then also taxed on the same earnings.
This also affects any shareholders who make up part of the business workforce and are registered as employees.
A simple way to understand this is by considering the status of a business owner. That owner will often receive a working salary and be registered as both the owner of the business and an employee. The salary itself is taxed, but so too are the profits on the company. Corporations that pay tax dividends on their profits will find that the business owner will also have to pay their own tax dividends when it comes to the time to file their own personal tax returns.
Why does Double Taxation Happen?
Not every business type is susceptible to double taxation. It is primarily those business concerns that have an ownership interest. Business models that don’t have to pay any corporate taxes are not typically double taxed. These include:
These business types are considered to be ‘pass through entities,’ meaning that any profits that they generate are generally paid directly to the owner of the business. That owner will then pay the tax on those profits via their own income tax returns. This method of direct taxation avoids the corporation taxation system by simply sidestepping it.
It’s worth noting that LLCs and Partnerships work slightly differently, yet the end result remains the same; they avoid corporation tax by filing their business tax report and the figures of their personal return.
Limited liability companies, S corporations, and sole proprietorships fall under this category. As they do not pay any form of corporate tax, there is no possibility of being taxed twice on the same profits. It’s important to understand that for small business, double taxation is something can be easily avoided. It is very rare that small businesses will have registered as a C corporation, and as a result, they can often prevent the potential of being taxed twice.
The Controversy of Double Taxation
Taxes are unavoidable, but finding out that you need to pay taxes on the same earnings twice can be very frustrating. Double taxation is often considered an ‘unfair tax,’ and as such is the subject of ongoing discussion regarding its place in the modern world. The consensus is that it is the only fair way to manage the profits of large corporations.
For those shareholders that feel they are being unfairly victimized by the IRS for their portfolio, it’s worth remembering that without that form of double taxation, it would mean that shareholders would not have to pay any taxes on the dividend income that they receive. This would make that revenue stream the only type of income that would be exempt from any tax payments. Rather than asking whether double taxation is fair, it’s important to consider the somewhat regressive alternatives.
There are flaws in the system, and these are largely due to the wide variety of ways that different businesses use their profits. When you consider dividends, smaller businesses tend not to pay them. This is because they use their profits, not for personal gain, but instead channel those earnings directly back into the business in the form of company acquisitions. This focus on growth means that earnings are not then considered as personal, and the need for double taxation is removed. This is far more challenging to achieve for larger corporations, who will have shareholders to satisfy and may not be able to justify equipment financing or other growth opportunities as easily.
How to Avoid Double Taxation
There are ways to avoid double taxation or to reduce the impact that it has on your income. Some of the ways to get around paying twice the taxes on your earnings are simpler than you might think, and you may already be doing some of them.
Step One: Pay Yourself
Even if it is your own business, you are still an employee. As such, you are entitled to a salary. This may, of course, mean that you may have to pay a higher tax rate on your personal income. However, considering that your salary will be tax deductible for your actual business, your overall tax payments may be reduced. The IRS will evaluate your role within the company if you start to pay yourself a salary. Your role in the business must be justified, otherwise the IRS will simply disallow your salary. This will lead to double taxation being inevitable. Remember, paying yourself the occasional bonus cash advance is not the same as paying yourself a salary. The IRS will consider any bonus as a potential dividend in disguise and will act accordingly.
Step Two: Paying Family
If you are paying yourself well, but you believe that the IRS will not tolerate a pay increase, then it is perfectly legal to hire members of your family and pay them a salary. They will need to prove that they play a role in the business. Known as income splitting, this is a common strategy for avoiding double taxation.
Step Three: Leasing
Assets are a great way to transfer money without the hassles of more complicated tax procedures. When it comes to industrial equipment financing, you can lease your assets directly through your company. This is far easier if you are an LLC, new business, or S corporation as it will reduce the potential for liability.
Taxes are always a complicated and stressful element of running any business. Nobody likes paying taxes, but the consequences of doing them wrong can be very negative indeed. Make sure that you understand exactly what your tax requirements are, and make use of professional advice. Chances are that your business will be able to reduce tax payments legally, leaving you free to consider the future of your business.