How does it work when a C-Corporation has double taxation?
When we say that a C-corporation is subject to double taxation, it refers to the fact that the corporation’s profits are taxed twice. Once at the corporate level and again at the individual shareholder level when the profits are distributed as a dividend. Here’s a breakdown of how this works.
- As a separate legal entity, a C-corporation is required to file its own tax return and pay taxes on its profits. The corporate tax rate is applied to the corporation’s taxable income after deducting eligible expenses and deductions. This tax rate is determined by the applicable laws and regulations in effect at the time. Currently, the Federal corporate tax rate is a flat 21% and the California corporate tax rate is 8.84%. These rates change periodically.
- When a C-corporation distributes its profits to its shareholders in the form of dividends, those dividends are considered taxable income for the individual shareholders. The shareholders are then required to report the dividends received on their personal tax returns and pay taxes on them at their individual tax rates. These are typically progressive and may vary based on income level.
What does this mean?
So, the same income is effectively taxed twice. Once at the corporate level and once at the individual shareholder level. This is the essence of double taxation for C-corporations.
It’s important to note that not all profits distributed by a C-corporation are subject to double taxation. Certain expenses, such as salaries and bonuses paid to employees, can be deducted at the corporate level. This will reduce the corporation’s taxable income. Additionally, if a C-corporation retains its profits and reinvests them back into the business, those profits are not immediately subject to individual-level taxation. However, if and when those retained earnings are distributed as dividends in the future, they will be subject to double taxation.
Double taxation becomes increasingly problematic when a business is sold. In most cases the buyers of a business purchase the assets of that business out of the C-Corporation as opposed to purchasing the stock of the C-corporation from the shareholders. This magnifies the two layers of tax. In essence the C-Corporation is paying tax on the sale of its assets and then giving a dividend to the shareholders who will incur an additional level of tax. In California these combined taxes can in the neighborhood of 60 percent.
On the other hand, S-corporations, partnerships, and limited liability companies (LLCs) treated as partnerships for tax purposes are not subject to double taxation. Instead, their profits and losses are “passed through” to the shareholders or partners. They report them on their individual tax returns and pay taxes at their individual tax rates. This avoids the double taxation issue associated with C-corporations.
How can I avoid the double taxation of a C-Corporation?
To avoid the double taxation associated with a C-corporation, you have a few options available. Here are some strategies that can help mitigate or minimize double taxation.
- Instead of distributing profits as dividends to shareholders, you can choose to reinvest the earnings back into the business. By retaining the profits within the corporation, they are not immediately subject to individual-level taxation. If you eventually decide to distribute those retained earnings as dividends, they will be subject to double taxation.
- Rather than distributing profits as dividends, you can compensate shareholders who are actively involved in the business by paying them reasonable salaries and bonuses. These compensation expenses are deductible for the corporation, reducing its taxable income.
- The Tax Cuts and Jobs Act (TCJA) introduced a deduction called the Qualified Business Income (QBI) deduction. It allows certain eligible pass-through entities, including sole proprietorships, partnerships, S-corporations, and LLCs, to deduct up to 20% of their qualified business income on their individual tax returns. While C-corporations do not directly qualify for this deduction, shareholders of certain qualifying C-corporations may be eligible to claim the QBI deduction on their personal returns. This will reduce the double taxation burden. You may consider converting your C-corporation to an S-corporation or an LLC treated as an S-corporation for tax purposes. S-corporations are pass-through entities, meaning they avoid double taxation. This conversion may have legal, operational, and tax implications. It’s crucial to consult with a tax professional or attorney to evaluate the potential benefits and consequences.
- Depending on your business circumstances, restructuring the C-corporation as a partnership could be an option. Partnerships are also pass-through entities. This means the profits and losses flow through to the individual partners. This avoids double taxation. This approach requires careful consideration and expert advice.
It’s important to note that these strategies have varying implications, and the choice depends on your specific business goals, financial situation, and tax regulations applicable to your jurisdiction.
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