Learn what double taxation means, how it works, and how it can impact your business depending on the business structure, assets, and investments.
What does double taxation mean? In simple terms, it means that something has been taxed more than once. Usually, this happens when business income is taxed twice, once at the corporate level and again at the individual shareholder level.
But there's more to it than just that. Whether a company will pay taxes twice or not will depend on the company's business structure. It can also depend on the company's capital gains, investment income, and more.
Understanding double taxation and how it works is important for any business owner, including small businesses. C corporations, s corporations, and sole proprietorships all have their own tax structure, and some may be subject to a corporate tax rate and personal income tax rate.
What is Double Taxation?
Double taxation is when two or more taxes are applied to the same thing by different jurisdictions or levels of government.
This can happen for a number of reasons, but typically happens to businesses or business owners when a business's profits are taxed twice.
For example, a business earns taxable income and then the business is taxed for that income and the business owner is also taxed for their share of that income.
Inheritances can also be double taxed. The assets included in the inheritance might be taxed as income or assets before they become an inheritance, and then taxed again after they are given to inheritors.
Basically, double taxation means exactly what it sounds like, when something is taxed twice. Understanding double taxation and how it works can help you make financial plans to avoid it and understand when double taxation could apply to you and your finances.
What is Corporate Double Taxation?
Corporate double taxation is when a corporation's profits are taxed twice. This can happen when the corporate profits are taxed at the corporate level and on an individual level for each shareholder.
Corporations earn profits and this income through profits goes both to the business and to any business owners and shareholders. Corporations pay a corporate tax rate on the income the business earns. Then, when the profit income goes to any business owners or shareholders it's subject to an individual income tax as well.
So the same income is taxed once at the corporate tax rate, and then again at an individual tax rate. However, the way corporate double taxation impacts businesses can depend on the type of business.
C Corp Double Taxation
A c corporation is a type of company that is taxed twice, at the corporate level and at the individual shareholder level. This happens because there are multiple legal entities receiving the business profits as income.
The business is its own entity, so when the business receives profits, those profits are taxed with a corporate tax rate. This can even affect self-employed individuals on their self-employment taxes if their business is a separate entity.
But then shareholders of the business also receive portions of this profit and what they receive gets taxed with individual income tax.
Here's an example of how c corp double taxation works:
Let's say XYZ Corporation has $100,000 in profits for the year. The corporation would pay corporate income tax on those profits, which let's say is a 21% tax rate, leaving the corporation with $79,000 after taxes.
Now, let's say the corporation decides to distribute $50,000 of those profits to its shareholders as dividends. The shareholders would then pay taxes on that $50,000 at their individual tax rates.
So, if a shareholder is in the 24% tax bracket, they would owe $12,000 in taxes on the $50,000 in dividends they received. This means the corporation's profits were taxed twice, once at the corporate level and again at the individual level.
S Corp Double Taxation
Alt Text: s corp double taxation
S corp taxes actually don't normally involve being taxed twice. An s corporation is a type of company that is only taxed at the individual shareholder level and not at the corporate level.
This happens because the s corp business structure makes the business a pass-through entity, allowing the business income to pass through directly to the shareholders. Then, this business income is taxed at an individual tax rate for the shareholders, rather than being taxed at a corporate rate first.
If a company wants to avoid double taxation, they can use the s corp business structure instead of the c corp business structure. This will make it so the business is only taxed once, at the individual shareholder level, and not at the corporate level as well.
However, there are cases where even an s corporation will be subject to double taxation. This can happen when an s corp has excess net passive income or built-in gains.
Excess net passive income is when investment asset income is higher than 25% of the s corporation’s gross receipts.
Built-in gains is when a corporation sells capital assets in a certain time period after changing from a regular corporation to an s corporation.
In these instances, an s corp will be subject to double taxation as excess net passive income and built-in gains will be subject to corporate tax and not only the shareholder's income tax.
Does Double Taxation Impact Sole Proprietorships?
A sole proprietorship is a type of company that has one individual that owns and operates the business. This type of business is not impacted by double taxation. With other types of corporations, business income is being received by multiple entities and people and is thus subject to multiple tax rates.
But with a sole proprietorship, there is only one individual that owns and operates the business rather than the business being its own separate legal entity.
This means the business income all goes to the business owner as the business owner's personal income and is only taxed once with an individual income tax.
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