How Does Double Taxation Work?
Think about it like this: In certain types of businesses, income will be taxed for both the business and the owner. In a C Corporation, revenues of $100,000 will be taxed for that money and anything the owner takes home as a dividend will be taxed again. That is what we call, “double taxation.” This could mean that a business owner would pay a much larger percentage of their incomes out in taxes.
Double taxation is one of the issues that will rear its ugly head in the course of running a business, and that’s before any worry about the IRS and audits comes into play. This occurs with both your business and you pay taxes on the same income or revenue dollars, and there are completely legitimate ways around it.
Owning a business can be rewarding, both financially and personally, but rewards don’t typically come without plenty of hard work. In the case of earning money from your business, there’s a lot more to the process than just collecting the check. Beyond the obvious challenges of getting a new company off the ground, you’ll have to worry about how to structure your business and what to do about taxes.
Let’s take some time to understand the different types of small businesses, how they’re structured, and how double taxation plays into the conversation.
How Do S-Corporations Work?
Unlike personal taxes and tax returns, things get complicated fast when talking about corporate tax issues. A good way to think of tax liability for an S Corp is this:
If you own an LLC and are taxed as a sole proprietor, your income is the business income and vice versa. If the business makes $50,000 corporate profit, you will pay Social Security tax and Medicare taxes on the $50,000 on a personal level.
In an S-Corp, let’s say your business made that same $50,000 profit but you’ve determined that your salary should be $40,000. Your salary is considered a business expense, so you’ll still report $50,000 of income, but you and your business will only pay Social Security and Medicare taxes on the portion of that income that went to your salary.
Avoiding Double Taxation
There are two business structures that allow owners to sidestep double taxation: Limited Liability Corporations (LLCs) and S Corporations. These business structures treat the company more like a person and “pass through” taxes from the company to the person running it. In an LLC, for example, a business profit of $100,000 would be reported on the owner’s personal income taxes. Another very simple example of this would an owner of an S Corp, whose business ran a $100,000 profit in 2019. The owner decides that $50,000 is a reasonable taxable income for themselves, so they pay personal taxes on that income. The remaining $50,000 can be distributed to the owner as a dividend, for which they will pay a separate tax rate. None of the revenues were taxed twice, but all went to the owner at the end of the day. That example is grossly oversimplified, but it illustrates the point.
S-Corporation versus LLC: As a sole proprietor, you have a choice between running your business as an LLC or as an S-Corp. The differences between the two may not seem that great at first, but the devil is in the details. S-Corps require that their owners be U.S. citizens or permanent residents. This includes partners, so the S-Corp structure may limit your choices for who is involved in the business. S-Corps also have a more complicated tax structure and may be burdensome for single business owners, as determining salary numbers and dividends can be tricky.
S-Corporations are also required to have a board of directors, they’re required to hold annual shareholders meetings, and make multiple formal business filings each year. There are also several other requirements around formal payroll processes, paperwork, accounting, and regulatory issues that don’t come into play with an LLC. If you’re looking to start an ultra-simple business without much headache for you as the owner, an S-Corp might not be the best direction to take.
Keep in Mind
- Limited Liability and taxation are different things. Liability refers to who is on the hook financially if something goes wrong and is not related to taxes. The differences also apply to how taxes and liability are treated in various business types, so be aware of the structure you’re working within.
- S-Corporations have several limitations that may make them a less than ideal choice for many business owners. There must be 100 or fewer shareholders in an S-Corp, but members of a family may be counted together as a single shareholder. If you determine that your business should be an S-Corp, you’ll need to make that election very early on in the incorporation process
- Tax rates and rules may vary slightly from state to state. In general, business structures are treated consistently across the country, but you’ll see different tax rates and rules from state to state.
- Certain types of businesses may have additional taxes or regulatory hurdles to clear. Professional services businesses, healthcare businesses, and others may have to pay extra taxes or licensing fees to operate, no matter their structure.
- As an owner of an LLC, you may be subject to self-employment taxes on top of your income tax. This is designed to compensate for the fact that you don’t have an employer paying those taxes and because there is no payroll deduction for those items as there would be in a typical employment situation
This has very obviously been a high-level intro to the world of business structures and taxation, and is not meant to be comprehensive or formal in any way. That said, it’s important to think about how you would like to structure your business before getting started. Some of the ideas we discussed earlier, especially the decision to set up an S-Corporation, require action very early on in the incorporation process. The decision to make changes further downstream will require a significant amount of paperwork and more hassle than if the change was made in the beginning.
No matter which direction you choose, it’s important to sit down with a tax advisor or legal professional to understand the intricacies of the structure that you’ve chosen. A person who is certified to advise business owners in the specific state or municipality that the business will operate in will also minimize the chances of running afoul of local tax laws, regulations, and documentation requirements.