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Question: My client owns a company organized as a C corporation. Isn’t double taxation a potential problem for him?
Answer: Many business owners are inclined to reject C corporation status because of double taxation. How does that work?
If a C corporation makes money, its taxable income is subject to federal income taxes. If, for example, in 2012, a C corporation makes $100,000 of taxable income, it owes the federal government $22,250. That leaves $77,750 after-tax profit.
If the company decides to distribute that profit to one of its shareholders as a dividend, the dividend is taxed again—this time to the shareholder.
Because corporate profits distributed this way are taxed twice—once at the company level, and once personally—the tax process is sometimes referred to as double taxation.
As a practical matter, double taxation hits most often at large, publicly traded companies where the potential tax effects of dividends on its shareholders is not a big concern for company management.
At a closely held business, company management and ownership are usually the same person or group of people. Where management has the ability to decide whether company profits will be distributed, it usually has the flexibility to decide to avoid double taxation.
Here’s one way it might do so. Say that Fred is the 100% owner of a C corporation, and he is also the company’s key employee. His company is on track to make $100,000 of taxable profit in 2012. Fred does not want that $100,000 of profit to be taxed twice.
Fred can decide to pay himself a bonus of $100,000 near the end of the year. So long as Fred’s overall compensation package is reasonable, the bonus is tax deductible by the company. So after the bonus is paid, the company’s taxable income is completely eliminated. There would be no corporate income tax on the profit—because the profit has been eliminated.
Fred does have to pay income tax on the bonus that he gets, but that’s the only tax that has to be paid. And that result is no worse than if Fred were organized as a pass-through entity.
Here’s another way that Fred can avoid double taxation. Instead of paying a dividend—or paying himself a bonus—Fred decides to keep the $100,000 profit, which is $77,750 after federal income tax, in the business. Fred and the company may use the money to buy equipment or to make another investment to help the business grow.
The business profit is only taxed once in the second example—at the business level. Because Fred doesn’t directly enjoy the profit himself, he doesn’t have to pay personal income tax on it. The money is used to re-invest in the business itself.
In some instances, being able to decide to keep company profits inside the business creates a lower overall income tax result than if the company is a pass-through entity.
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