C corporations are often the best planning option for business entities. However, fears of the dreaded “double-taxation” may lead some to reject C corps without a closer look. But double taxation can be reduced, and in some cases avoided, making it an option worth considering. Attorneys seeking to maximize tax savings for their clients should investigate whether C corps are a good option for their estate planning. Simply put, double taxation means that the C corp is taxed on its income at the corporate level, and then its shareholders are taxed on the same income when it is distributed to them in the form of dividends. Understandably, this is a situation most want to avoid or minimize.
Here are three ways to reduce or possibly eliminate the problems of double taxation with C corps:
Retained Earnings: One way to avoid double taxation is simply to retain corporate earnings. By retaining the income rather than distributing it to shareholders as dividends, the second layer of taxation can be avoided. This is not an option for entities whose owners rely on cash flow from the corporation, but it works well when the owners can afford to reinvest the cash in the corporation to grow the business.
Salary Distributions: Alternatively, the corporation can distribute its income in the form of salary or bonus, rather than dividends. The salary or bonus will be taxable to the recipients, but it will also be a deductible expense for the corporation. This strategy may be more effective in a corporation whose income is primarily derived from operations. Since the company’s income is earned by the efforts of its employees, it is more difficult for the IRS to challenge a corporation that is paying out that income as salary.
Income Splitting: Income splitting refers to a situation in which business owners withdraws as much of the corporate profits as they need to support their lifestyle, but leave the rest inside the corporation. Since C corps and individuals are both subject to progressive tax brackets, income splitting minimizes the effects of double taxation. By taking only a portion of the corporation’s profits out as salary (a deductible expense to the corporation), and leaving the rest of the profits in the corporation for reinvestment, both the owner’s gross income and the corporation’s taxable income are reduced.
C corporations are often an excellent but overlooked choice in estate planning. Through proper tax planning, double taxation may be reduced or eliminated. The choice of business entity is a decision to be made based on the particular circumstances of a given business and with input from a tax advisor. If a C corporation is the optimal form for your client, you can use these and all available strategies to reduce the effects of double taxation.
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