What is Double Taxation and How You Can Avoid it.
Building a new small business can be highly rewarding but at the same time can also be quite a challenging task. There are several factors that a small business owner needs to weigh in to make sure that they get maximum profits from their business venture. Among thousands of factors, one of the first things that a founder of small business needs to take into account when starting off the ground is the kind of business structure it plans to operate as, and also the way it plans to deal with the taxes. Understanding the different types of double taxation for businesses is important in determining the kind of business structure one chooses.
What is double taxation?
As the term goes, double taxation refers to the levy of taxes twice on the same source of declared income by the businesses. Small businesses that choose to run as Corporations are subjected to double taxation on their income. The income as declared by a small business electing to work as a corporation needs to pay tax both at the corporate level as well as on their dividends earned as a shareholder.
To elaborate on the point further, take for example the profits earned by the small business corporate are first taxed by the corporation in the form of the corporate tax, and again when the same profits are being distributed to its various shareholders as a dividend then the income tax authorities of the United States- IRS – decides to levy the dividend tax on it and this is known as double taxation. Owing to the tax being levied both at the income source and also at the dividends distributed to shareholders of permanent establishments, double taxation is also being commonly referred to as the dividend taxation system. In other terms, as per the tax law, the individuals in the US are required to pay taxes on their dividend income when they receive a share of their profits as shareholders, which are previously taxed at the corporate level too.
Choosing an Incorporation Type For Their Tax Considerations
The legal form of business structure that one chooses has a significant impact upon the several components of the business, including the way it functions, the amount of taxes it has to pay on its profits and also the legal documentation and paperwork it has to file for its hassle-free and legalized operations. Choose a legal business structure that provides you with optimum benefits and lets you guard your business wealth against heavy tax liabilities. Each legal form of business deals with tax liability differently. Some businesses have to pay taxes at the declaration of their income level, while some are double-taxed at both the business and personal income levels.
Read on a little more to understand the tax considerations when incorporating a business and taking a legal form.
Sole proprietorship tax considerations – Sole proprietorship is when a business is controlled and owned by one person. In this most common form of business structure, there is no separate business entity as the business assets and liabilities are not separate. As per the IRS’s perspective, all of the assets and liabilities, as well as the income of a business, directly belong to the business owner solely. When filing their personal tax return, sole proprietors include both their business expenses and personal income on their investments.
General Partnership tax considerations – A business can assume a partnership form of structure when it is controlled and owned by two or more individuals together. Similar to the sole proprietorship where the business and owner treated legally as the same entity and have to pay tax just at their personal levels, the partnership form of business structure is also exempted from double taxes under the federal law. The income of the business from the partnership business type is taxed to the individual partners of the entity. Hence, the partners are required to pay their personal income taxes as per the individual tax rates. For tax purposes, all types of income from the general partnership must be “passed-through” to the partners, who are then liable to pay taxes on their individual profits.
Limited partnership (LLP) tax considerations – In this form of business structure, there are both general and limited partners. While the general partner will control and have a say on all business and legal matters pertaining to the operations, the limited partners typically have no crucial business decision rights and only are there as investors. They differentiate from general partnerships in their ownership terms. In the case of a general partnership, general partners assume full control and responsibilities for their business. Meanwhile, limited partners get ownership without bearing the risks and responsibilities associated with the business. Income from the LLP must be “passed-through” to the partners, which are then taxed at a personal tax statement.
Limited liability Company (LLC) tax considerations – A limited liability corporation (LLC) separates business and personal liabilities and all owners have shared tax responsibilities. Under federal tax laws, the LLCs are treated like partnerships unless they elect to be categorized as corporations.
The LLC taxes can be passed at the personal income level thus owners can enjoy tax relief. Like the corporations, the LLC provides the owners with the benefit of liability protection as there is no international double taxation on the worldwide income earned, depending on the tax treaty with other countries. Owners in LLCs are not obliged to pay off their business debts as their personal liability is limited.
Each state treats LLC differently and hence the tax liabilities that a limited corporation has to bear also vary depending on the state laws. It is best to check with the state for specific LLC regulations.
C corporation tax considerations – Business can file for a separate legal entity to form a C corporation. Such businesses are subjected to corporate income tax. Hence, the corporate profits earned from the business are taxed at the corporate level using the corporate income tax rates. Also, the income from the business distributed to its shareholders in the form of dividends is taxed in the hands of shareholders. Hence, the C corporation income has to bear the double taxation. First, the tax is levied on the income at the corporate level and then again on the owners’ dividends received from the business.
S corporation tax considerations – Businesses who have filed with the IRS to be treated like a partnership (or LLC) for tax purposes are known as S corporation. These corporations are not required to pay corporate income tax. Instead, they have a “pass-through” tax system, wherein the income or the loss of the business is passed through to the owners and shareholders. Hence, such businesses do not have to bear the double tax burden like the C Corporation.
The link between Double Taxation and Business Legal Structure
Based on the above analysis of different forms of legal business structures, we can conclude on below:
Businesses facing double taxation:
- Corporations or better known as the C Corps
- LLCs that choose to categorize their business as the corporations
Businesses that can avoid double taxation:
- Sole proprietorships
- Limited liability companies (LLC)
- S corporations
The legal form that a business takes on is the most important determinant of the tax structure that it has to bear throughout its operational years. A business can also change its legal forms to bring in more owners and also to protect the business’s wealth from incurring more liabilities in the form of taxes. Hence, it is important to weigh in the taxation system associated with the different types of business structures when deciding on the type of legal forms you choose to go for.
Realizing The Pitfall of Double Taxation and Avoiding It
All businesses look to safeguard their wealth from tax liabilities so that they could invest the saved earnings back into their operations and earn more returns. From a legal standpoint, a C Corp is seen as a separate entity that files its own federal and state tax returns as per the income tax system. Knowledge of some smart tricks to avoid double taxation for your business can help achieve optimum tax savings. Below are some of the things that a payer should bear in mind to prevent getting their business double-taxed.
Ensure not to structure your business as a corporation – Assuming the legal form of your business as a sole proprietorship, partnership, LLC, or S Corp will work best for those looking to avoid getting their business revenues double-taxed. Businesses with these structures have “pass-through” taxation that lets the business to pay taxes at the personal level.
Make employees the shareholders and avoid distributing dividends – Adding employees as shareholders for smaller corporations can help businesses steer clear of the double taxation system. Employees or shareholders of the corporation will be required to pay income tax only on their earnings. Also, the salary of these employees will be treated as a business expense for the corporations, thereby reducing the taxable income of the corporation. This will, in turn, lead to a lower tax liability for the corporation. However, salaries need to be justifiable to the IRS. Tax savings can be invested back into the business for further growth. Also, distributing dividends to the shareholders create a liquidity drain on the part of the corporation as liquid cash might not be available immediately. By re-plowing the profits, we can stop this liquidity drain for the business.
Employ family members – Another smart way to save the business from double taxation is to add family members as salaried employees for the business. Showing the salaries as business expenses for the corporation is another way to take out money from the corporation as fixed costs to businesses without paying taxes on it first.
Borrow from the business – Business owner taking out a loan from the corporation is exempted from tax. It is not treated as a taxable dividend, rather a loan asset on the corporation Balance Sheet. However, the loan is being carefully inspected by the IRS to ensure that it does not serve as a disguised dividend. Doing this would require the business owner to pay back the loan into the corporation at reasonable interest rates. Interest payments received by the corporation for the loan will be taxed as income for the business.
Establish a separate pass-through business structure to lease equipment to the C Corporation – Set up a flow-through business structure that can purchase equipment and lease it to the C Corporation. This will allow flow-through income created for the LLC and also enable the corporation to file for a corporate income tax deduction for payment of lease rentals on leasing the equipment.
Elect to be seen as S corporation tax status – After creating a corporation, business owners can request the IRS to treat it as an S corporation for tax purposes. The same liability-limiting features of C corporations apply to S corporations but their profits go directly to shareholders, thus avoiding double taxation. However, only certain corporations that meet the requirement of a certain number of shareholders and hold a certain class of stock are given a status of S corporations.
How The Double taxation Treaty With Other Countries Work In The United States
All countries require multinational corporations and non-resident business owners operating within their borders to pay taxes on the profits made from their country. The United States also has specified foreign tax laws, requiring minimum tax to be paid on the profits that the US-based multinationals earn in foreign countries with respective low tax rates. Taxes are imposed on the US-based companies earning foreign income but they also enjoy the credit of around 80% of the taxes paid. However, most countries do exempt taxes on foreign income of their multinationals having proof of their operations in other countries of residence. The US tax laws also have an allowance for the foreign tax credit by which the amount paid as taxes by non-residents or multinationals in their country of residence can be offset against the income tax liabilities they bear on any foreign income not covered by the tax exemption laws.
The United States allows a foreign tax credit to help the resident to mitigate the potential drawbacks of the double taxation on worldwide income. By allowing the foreign tax credit, income tax paid to foreign countries can be offset against U.S. income tax liability attributable as per the domestic laws.
The US also has in place a lot of tax treaties and double taxation agreements in place in which they set out clear rules for businesses to avoid getting their earnings taxed twice. Tax treaties provide for an exchange of information to stop cases of tax evasion from happening. For example- when a person files for tax exemption in one country on the basis of being a non-resident there but at the same time do not declare it as foreign income in its home country then tax treaties help in preventing tax evasions. The US has tax treaties with many foreign countries owing to which the residents of those countries can enjoy a reduced tax rate or are exempt from the US income taxes on certain gains from sources within the US. Income subject to withholding tax may be exempted due to these treaties or they may be subject to a reduced tax rate.
Take into account the significant income tax consequences with respect to each of these business forms and income tax treatment across different geographies of its operations. A small business trying to expand its footprint outside of the US should take into account Double Taxation Avoidance Agreements between countries. Also, other factors to weigh in include transfer pricing rules, capital gains tax issues against the non-tax issues when filing the tax returns.