As you investigate business planning options, resist the impulse to automatically reject C-Corporations due to fears of something dubbed “double taxation.” While this is a common fear, and in some cases justified, C-Corps can offer benefits significant enough to offset the downsides. More to the point, double taxation on C-Corps can be reduced or even eliminated with the right planning.
But first, what is double taxation? Double taxation is the idea that, due to how they are structured, C-Corps owners will be taxed twice on business earnings. First, the C-Corp is taxed on income at the corporate level. Then, dividends to shareholders are taxed once again upon distribution.
But that’s not the whole story. Depending upon the exact situation, the following three strategies might be used to reduce double taxation or avoid it entirely.
Retained Earnings. In this scenario, the choice is to simply retain corporate earnings instead of distributing it to shareholders via dividends. This strategy eliminates the second part of double taxation. However, if owners rely on cash flow from the corporation, this won’t be the appropriate strategy. Retained earnings works best when owners are willing and able to reinvest earnings into the company, such as for the purpose of growth.
Salary Distributions. If the organization’s income is primarily derived from operations, this strategy can be appropriate because the IRS is less likely (and able) to challenge a business that pays out profits as salary. With this strategy, the C-Corp distributes earnings as salaries or bonuses, rather than dividends. Recipients will indeed pay taxes on their income, but the distributions will serve as a deductible expense for the corporation itself.
Income Splitting. And finally, Income splitting allows the C-Corp owners to withdraw enough profits to provide adequate income, while leaving the rest in the business account. Since C-Corps and individuals are both taxed based upon progressive tax brackets, splitting income this way can keep both the business and its individual owners in lower income brackets. This strategy doesn’t exactly eliminate the concept of double taxation, but does lower taxes of both types.
If a C-Corporation might be an ideal structure for your business, consult with our business planning attorneys about your concerns regarding double taxation. We can help you determine if one of these methods could work for your situation, helping you to reap the benefits of a C-Corp structure while mitigating the taxation risks.