Taxes are compulsory payments imposed on corporations and individuals by government entities at the local, regional, or national levels. Tax revenues fund the government’s various activities, ranging from Social Security and Medicare programs to public services and infrastructure such as schools and roads.
In economics, the tax burden falls on the individual or entity that pays the tax, and this could be the end consumer of a business’s products or the business itself. As a small business owner, understanding taxes can be daunting, and one of the most significant tax challenges faced by sole proprietors is the issue of double taxation.
What is Double Taxation?
A tax principle that refers to the income taxes paid two times on the same income source. Double taxation can happen when the income is taxed on both personal and corporate levels. It can also happen in investment or international trade when the same income gets taxed in two countries.
Double taxation mostly happens because corporates and shareholders are perceived as separate legal entities. And so, corporations, like individuals, also pay annual taxes on their earnings. The dividends that corporations pay out to shareholders endure income-tax responsibilities for the receiving shareholders, even though the earnings that provide the money to pay the dividends has already been taxed at the corporate level.
It is, in most cases, a tax legislation accidental consequence and is commonly seen as a bad tax system element. Tax authorities try their best to avoid double taxation whenever it is possible to do so. By using tax credits and varying tax rates, many tax systems try to have an integrated system so that both the income earned directly by individuals and those earned by corporations paid out as dividends are taxed at the same rate.
Double Taxation on Small Businesses
Small businesses registered as C corporations are taxed twice on business profits. They pay taxes first on their profits, and then stockholders have to pay taxes for their personal income on the dividends paid from the company’s profits. The personal income tax rate that the shareholders must pay on their dividends and wages received after the corporate taxes are paid can be between 12 to 37%.
Some business entities only pay income tax once, like sole proprietors, non-corporate LLCs, and partnerships. They use a type of taxation called “pass-through taxation” because the income passes through the business to reach the individuals or the owners, who are taxed directly.
For example, if the small business had a tax rate of 21 percent and had $100,000 in profits the past year, it owes the IRS $21,000 in taxes. And the shareholders must pay individual taxes on the wages and dividends they might have received from the remaining $79,000.
How are Sole Proprietors Taxed?
Sole proprietorships are considered the most basic business structure in the US. They do not require filing fees to get started, paperwork, or even a separate bank account. They are the known business structure for businesses that individuals own.
For example, people that start a side job as independent contractors are automatically considered sole proprietorships by the IRS. Sole proprietorship taxes are called “pass-through taxes” because the business’ profits pass through it to be taxed on the individual’s personal tax return, and sole proprietors are treated as one with their businesses for tax purposes.
So, are sole proprietorships double taxed? The answer is no. Sole proprietorships are taxed just like their owners were before starting the businesses, at the individual tax rate. They do not report their income and expenses like corporations do on separate business tax returns; they do it on their personal income tax returns.
One big difference between doing taxes as an employee and doing it as a sole proprietor is that the sole proprietor must report the losses and profits of their business on an added IRS form (Schedule C).
Some beneficial tax strategies exist for small businesses; for example, sole proprietors can deduct some expenses from their taxable income to result in a smaller tax payment. Some of the most popular tax deductions among small businesses owners are:
- Self-employment taxes
- Health insurance
- Business use of vehicle
- Home office deduction
- The Qualified Business Income deduction
How to Avoid Double Taxation on your Sole Proprietorship
A sole proprietorship does not pay double taxation; C corporations are the only type of business that has to pay double taxation. To be clear, the corporation pays taxes only once, then when dividends are paid to shareholders, double taxation occurs, and the shareholders get taxed at the individual rate also after already being taxed at the corporate rate.
Organizing the business as a pass or flow-through entity allows it only to be taxed once. This ensures the profits are only taxed on the individual or personal rate (the owner rate), and by so, double taxation is avoided.
There are several strategies that C corporations owners that would like to avoid or reduce double taxation can do, like:
- To avoid corporate tax on earnings, refrain from distributing them to shareholders as dividends.
- Consider paying higher salaries to shareholder-employees instead of dividends, as personal income tax rates may be lower. Ensure that these salaries are justifiable to the IRS.
- Family members who work for the corporation can also receive salaries as long as they are justifiable to the IRS.
- Instead of receiving taxable dividends, corporation owners can take loans from the corporation. However, the IRS may investigate to ensure these loans are not disguised dividends.
- Setting up a separate flow-through business allows for leasing property or equipment to the C corporation, resulting in flow-through income for the new business and a deduction for the corporation.
- The owner of a corporation can request that it be considered an S corporation for tax purposes. This status allows profits to flow directly to shareholders and avoids double taxation. However, S corporations have limitations on the number and type of shareholders and stock classes, so it may not be suitable for all corporations.
Final thoughts
Tax planning must be vital to any business strategy in small businesses considered pass-through entities and C corporations. A strategic approach to the business structure can substantially boost the business’s profit. The business owner must consult a qualified financial advisor about double taxation and the small business they plan to start.
S and LLC corporations offer a pass-through tax treatment and will protect the owner’s assets from potential company liabilities. The choice of a business structure depends on the business’s unique aspects.
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