When choice of entity is discussed early in the planning stages for new businesses, C corporations are often quickly taken off the table because of their notorious double taxation. Double taxation refers to the fact that the corporation 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. But double taxation can be mitigated, and in some cases avoided, making it a more viable option.
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 have income from other sources and 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. If, on the other hand, a corporation’s income mainly comes from assets or other investments, then there is greater risk of the IRS re-characterizing some of the “salary” distributions as dividends. Re-characterization of salary distributions is less likely to occur in service oriented corporations. 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 is another technique to minimize the effects of double taxation. Income splitting refers to a situation in which a business owner withdraws as much of the corporate profits as he needs to support his lifestyle, but leaves the rest inside the corporation. Since C corporations 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.
Takeaway
C corporations are often an excellent but overlooked choice. Through proper tax planning, double taxation may be reduced or eliminated. Choice of entity is a decision to be made based on the particular circumstances of a given business and with input from a tax advisor. Don’t be spooked by double taxation! If a C corporation is the optimal form of business entity for your client, utilize available strategies to mitigate the effects of double taxation.
