Which Business Form Does Not Avoid Double Taxation
If you form a corporation and then file an election to be taxed as an S corporation for federal purposes, you do not automatically assume that your state recognizes the federal election. The burden of double taxation is common and significant for businesses and shareholders, but it is not inevitable. There are several ways for entrepreneurs to avoid double taxation or reduce taxation. Because a corporation is a taxable entity separate from its shareholders, profits that remain at the after-tax corporate level are not taxed to owners when they are earned, as in the case of unincorporated corporations and S corporations. Profits are taxed only if they are actually distributed in the form of dividends to shareholders. Please note that these examples are too simplified to introduce the concept of double taxation at the highest level. As expected, nothing is this simple when it comes to the world of corporate tax. Discussing your particular situation with a trusted tax advisor or accountant can help you determine the business structure and tax treatment that is best for you. A corporation is incorporated under state law: they must be incorporated in a specific state. Once your business exists under state law, you may consider having it taxed as an S corporation under federal tax law by making an election using Form 2553, Election by a Small Business Corporation. The Internal Revenue Code levies self-employment tax on profits from business property, plus any guaranteed salary payments.
The owner will not be “in business” by renting real estate (or equipment, furniture, etc.) or making loans. Therefore, the tax is not levied on these revenues. (In addition, the Code also explicitly exempts lease payments received from anyone except a real estate agent.) Lease payments and loan repayments are paid to the LLC owner for a reason other than his or her capacity as owner. As a result, they are deducted by the LLC when calculating their distributable income. Since the LLC itself doesn`t pay taxes, this really represents a way to allocate income to a specific owner, but avoid self-employment tax. Organizing a business as a corporation can bring many benefits, such as: protecting business owners from personal liability arising from business debts and the ability to raise capital through the sale of shares. Integration also has its drawbacks. One of the most important is that corporate profits can end up being taxed twice by the government.
However, tax legislation offers small businesses a way to circumvent this “double taxation”. The biggest differences between forming an LLC and forming an S company arise when dealing with more complex issues of tax, corporate structure, and regulatory compliance. If Anne operates her business as a sole proprietor, she must pay income tax (and self-employed tax) on the $500,000 profit. It will have to pay tax on this amount, even if it puts a large amount into a savings account, to be ready for expansion in the years to come. Many commentators suggest that an LLC has a tax advantage over a corporation because the “double taxation” of dividends can only apply to a corporation. The LLC is not a separate taxpayer and does not pay dividends. Therefore, the concept of double taxation does not apply to LLCs (unless an LLC is treated as a corporation for federal income tax purposes, which would be a rare event). But even with a regular C corporation, this tax is usually easy to avoid using a combination of these strategies: In practice, however, the absence of “double taxation” of dividends in the LLC is likely to provide minimal benefits to the small business owner. In a small business, owners may avoid paying dividends and instead withdraw deductible cash from the business, such as salaries, lease and loan payments, etc. The very high salaries of small business owners were maintained as deductible expenses.
In fact, most small businesses do not pay dividends and still distribute all disposable income to owners in this tax-deductible manner. If you own an LLC, you can deduct half of the self-employment taxes you pay on your Personal Income Tax Return Form 1040. This can be done even if you don`t list the deductions. This fact can reduce the effective cost of taxes and thus transfer the benefit to the LLC. While the company can deduct half of these taxes on its own tax return, it does not bring any direct benefit to the owner because the company files a separate tax return and pays its own taxes. When comparing the limited liability company (LLC) and the corporation, there are significant differences in how each type is billed at state expense, operated under state law, and taxed by federal and state governments. If the accumulations are not related to the reasonable needs of the business, a cumulative income tax of 15% is levied in addition to the regular corporate income tax. But let`s face it. When it comes to choosing a business structure, small business owners are usually concerned about one thing: taxes. Raising awareness of double taxation helps you and your tax advisor minimize its impact. But now that the highest personal tax rate is 39.6% and there is a net capital gains tax, the tax disadvantages are much smaller than they were a few years ago.
Tax planning should be an integral part of your business strategy. This applies to flow-through entities and C entities. A strategic approach to your company`s structure – who you employ, how much you rent equipment or space, and compensation, including dividends – can lead to a significant increase in your company`s profits.
