The Truth About C Corporations and Double Taxation


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4 Comments

gavelIf you’ve heard C Corporations are bad, you’ve probably heard the reason is because of something called double taxation. That’s bad, right? Who wants to pay double tax!

But, do you really know what double taxation is?

Double taxation occurs when a C Corporation pays a dividend to its shareholders. The term comes from the fact that the C Corporation pays tax on the profit of the company and then pays out a dividend which is taxable to the shareholder. The dividend is not a deduction for the C Corporation. So both the shareholder and the C Corporation pay tax.

What if the C Corporation pays a salary to its shareholders? In that case, it would be a deduction for the C Corporation and it would be taxable to the shareholder. So there is tax, but only at one place – the shareholder.

What if the C Corporation pays for employee benefits for the shareholders? In that case, it is a deduction for the C Corporation and there is no tax to the shareholder. It’s the exact opposite of double tax. It’s tax free!

Of the three ways that a shareholder can be paid, only one results in double taxation. The solution, I think, is pretty simple. In the case of a small closely held C Corporation – don’t pay dividends!!

That’s how you avoid double taxation in a C Corporation.



4 Comments

  1. Diane Kennedy says:

    PS:

    Regarding the farm in a high tax state. Well, part of it is going to depend how the tax is calculated. If it’s based on a net income number, like CA is, then look for ways to take as many expenses as possible against that state’s income. For example, if I lived and had a business in TX and a farm in CA. I know that my TX biz is going to get hit by Margin Tax no matter what. The expenses I have don’t matter. So if I have an expense that could go either way, I’ll send it against my CA farm.

  2. Diane Kennedy says:

    PS, I think you’re talking about the 3.8% surtax on passive income. At this moment, it does NOT include S Corporation distributions. It applies just to rents, royalties, capital gains and the like. But NOT S Corporation.

    As far as the question of excess compensation, absolutely that can be a problem with a C Corporation. If your income is too high through a salary, they could call some of it a dividend.

    I prefer to use a combination of S Corp and C Corp to get the best of both worlds.

  3. PS says:

    DIane – any thoughts on how to avoid nexus and taxation in a high tax state when the basis of the business (farming) is land ownership in the high-tax state?

  4. PS says:

    Diane – thinking about converstion to Sub S from a C Corp (only one s/h) – me!). Will Obamacare affect the sub S distributions by requiring the nearly 4% additional tax on distributions above compensation levels? If so, wouldn’t a C Corp be a better option on this issue alone?

    Also, increasing compensation in a C Corp to avoid double taxation of dividends is great but at a certain point don’t you risk having “excessive compensation” being tagged as a dividend in disguise and recharacterized?

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