Whether you’re an employee of a corporation or a shareholder in a big business, it’s likely that you’ll have come across the term double taxation. Although it’s only a concern for C corporations, it’s important to be aware of this term, what it means and what its impacts can be on your profit. But what is double taxation? Learn more about what double taxation refers to and how to avoid double taxation.
What does double taxation mean?
If you’re a shareholder of a C corporation, whether that’s through your own individual investment or employment through the company, then you’ll pay taxes on any dividends you earn through the corporation's earnings. This is despite the fact that the corporation will already have paid tax on their profits or earnings.
Mostly double taxation refers to the profits of established corporations who often contribute a share of their income towards their shareholder’s dividends. If you’re both a shareholder and an employee of a business, then both your salary and your dividends are subject to being taxed on your personal income return. This means you’re being paid from the corporations taxed earnings and therefore subject to double taxation.
Double taxation example
Here is a double taxation example to demonstrate how it works.
In the 2020 tax year, corporations were taxed at the corporate rate of 21%. This means that a company that earned $2 million in the tax year of 2020 had to pay $420,000 in corporation tax. If they paid each of their shareholders $20,000 in dividends, then each of their shareholders would have to include that in their personal tax return and therefore make it subject to their own personal tax rate.
In 2020, this could be as high as 37% for single taxpayers earning more than $518,400 in that tax year, or more than $622,050 for married taxpayers who file jointly. Between the corporation and the shareholder, tax is effectively paid twice on any earnings that are made, hence the term double taxation.
What does double taxation mean for a corporation?
Currently, only C corporations are subject to double taxation due to their dividends being divided out between shareholders. Any profits from S corporations are passed down to owners and taxed based on their individual tax returns. This is the same for LLCs, partnerships and sole proprietor businesses, known as “pass-through” entities who pass their income to their owners, who then pay take through their individual returns.
If you’re part of any business other than a C corporation, it’s important that you check how to correctly file your income and earnings so you don’t accidently become subject to corporate tax rates or double taxation.
How to avoid double taxation
If you’re an employee or shareholder of a C corporation business, then it’s impossible to avoid double taxation. If you receive any dividends from a corporation then this must be included on your personal tax return and therefore be subject to your personal income tax rate.
If you hold your dividends for a long time, then you might meet the requirements for qualified dividends, which give you a lower tax rate. However you will still undergo double taxation, just at a lower rate. Some C corporations also have alternative payout policies which allow you to defer paying personal income tax on your dividends until the corporation distributes its earnings in the future or you (as a shareholder) sell your stock at a price that reflects the value of any retained earnings.
For directors and CEOs of corporations, double taxation may make you consider whether you want to elect not to pay dividends. This means the corporation pays the whole tax bill on any business income, rather than it being shared out amongst individual stakeholders.
Restructuring your corporation as a partnership, LLC or other “pass-through” entity may be another option if you want to minimize the impact of double taxation on your personal and business earnings. However, pass-through profits are currently subject to a higher tax rate of 37%, so it’s worth approaching this type of organizational restructuring with caution.
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