Double Taxation: Avoiding It! By Understanding Corporate Dividends If you are currently operating as, or plan to form, a C-Corporation (a corporation that has not filed an s-election with the IRS) then you have probably heard the term "Double Taxation". By Jennifer Reuting , author of Limited Liability Companies for Dummies™If you are currently operating as, or plan to form, a C-Corporation (a corporation that has not filed an s-election with the IRS) then you have probably heard the term "Double Taxation". In order to understand double taxation, you must first understand how corporations are taxed. Corporations are considered entities unto themselves and are completely separate from their owners (called "shareholders"), thus they are also taxed separately (called "corporate taxation"). Unlike sole-proprietorships where all income is considered taxable, then you are allowed certain deductions, corporations are taxed solely on the profits, right from the get go. To put it simply, whatever is left over in your corporate bank account plus any disallowed expenses (such as when you used your corporate card to pay your dog's vet bill) is what is taxed. Great right? Well, maybe… after all, all roses have thorns and corporations are not exempt. As a sole-proprietorship it is easy for you, as an owner, to take money out of the business. You don't have to make any formal distributions of profit - you just write yourself a check. As a sole-proprietorship, all of the money is pretty much considered yours right from the get go. However, corporations are different. Being entities completely separate from yourself, the IRS requires you and your Corporation to keep all income and expenses separate. Corporations are superior entities, for sure, but along with the refinement comes restrictions. Shareholders can only remove profit from the Corporation according to their ownership percentage. For instance, if you own ten percent of the company, you are legally only allowed to take ten percent of the profit. These payments of profit to the shareholders are called Dividends. What Is Double Taxation? Now, how does double taxation work? Well, in a sole-proprietorship, because the money is considered yours from the get go, you only have to pay tax on it once - on the personal level. Unfortunately for most people, this personal tax also includes self-employment tax, which can be astronomical. But corporations first pay corporate taxes on the company profit then, when that profit is distributed to the shareholders in the form of Dividends, the shareholders are then also taxed. In other words, the corporation is paying corporate taxes on the profits at the corporate level, then the shareholders are paying personal taxes on those same profits at the individual level. So, unless you plan on keeping the profits in the company, they will be taxed twice as they flow through to the shareholders.

Leaving money in the corporation can be a good short-term plan, but unless that money is spent, you could be facing an Accumulated Earnings Tax, which is approximately 39.6% in addition to the regular corporate tax already applied.

Keep in mind that you cannot issue a dividend if the corporation isn't recognizing a profit. This is especially bad if the dividend causes the corporation to go bankrupt or even just makes it so it is unable to pay debts.

Ways to Avoid Double Taxation When you start a corporation, there's a good chance that it isn't for the hours or labor, sweat, tears and stress of it all. No. It's for the reward! A reward that, preferably, after taxes, will be substantial. In order for this to happen, you will oftentimes have to take money out of your corporation in varying forms.

It doesn't matter how good your intentions or foolproof your paperwork, the IRS is allowed to disallow any transaction they like. They don't have to be fraudulent, just questionable - which, needless to say, is a very broad term. If they do this, not only will you then be required to pay applicable taxes on the disallowed transactions, but you will also be responsible for paying interest and penalties. Therefore, it is important that you make sure that all of your transactions make sense and will pass the roving eye of any potential IRS auditors.

In addition, part of Delaware's allure is the hundreds of years of case law that has developed over so many centuries. Delaware was a pioneer in the 1800s for corporations. Before California was even admitted into the union, Delaware was one of the first states to privatize the then-government-controlled corporate entities. They soon followed by loosening restrictions and lessening the tax burden on corporations. From that day on, Delaware has been a force to be reckoned with. Take a Salary As an officer/employee of the corporation, you are allowed to take a salary. While you may have to pay taxes at a higher personal income tax rate, keep in mind that your salary is deductible to the corporation. Therefore, you will actually be subject to less taxes overall. In order to take a salary, you must justify your role in the business. You must be considered "hands on" and be a pertinent part of the day-to-day business operations. If the IRS doesn't feel that you pay a critical role, then there is a good possibility they could disallow your salary, consider it a dividend and subject the funds to double taxation. If you aren't currently working hard in the business, but still dedicated the blood, sweat and tears to building the business (all while being underpaid), then this might also help substantiate a higher wage. A question that I often receive is, "How high a salary can I pay myself." The answer to this question is largely determined by what the IRS considers "reasonable." A few things factor into this "reasonability test," such as how your salary compares to similar positions in other competing firms, how much time you dedicate to your position, whether your salary is in line with the company's growth and profit and how much you earned in other jobs. If your salary is a percentage of company sales, I recommend that you keep the percentage constant throughout the year.

Beware of Bonuses! Need cash? I personally know how tempting it is to take a lump of cash out of your corporation and just classify it as a bonus, but don't go there. The IRS usually considers unfounded bonuses to be nothing more than "Disguised Dividends." If you have a good reason for it (for instance, you acquired a big account) then a bonus will usually be allowed, as long as it, together with your salary, doesn't amount to unreasonable compensation for your position.

Put Your Family Members on Payroll So you've maxed out the amount of money you can reasonably take via a salary, what now? Well, why stop with yourself? Start putting your family members on the payroll too! This is called "Income Splitting" and is perfectly legal as long as your family members are legitimate employees and aren't being paid extreme amounts for the position. In addition to keeping your personal income under a reasonable amount, this also keeps you in a lower tax bracket. If your kids do odd jobs for you company, feel free to place them on payroll as well. Just make sure that you adhere to the child labor laws in your state as well as keep detailed and accurate records. Children automatically get a lower tax rate than adults. Personal income tax on a child's wages starts at around 15% and stays there for a while. And don't worry - you can still claim your child as a dependant on your personal income tax return! Borrow money If you are in dire need for a chunk of change ASAP, borrowing money from your corporation is usually your most viable option. Luckily, there are not too many tax consequences on corporate loans to shareholders. As a matter of fact, the first $10,000 is completely free from taxes consequences and/or interest requirements. This is called a "de minimus exception." If you are borrowing over $10,000 in the period of a year, and are paying little or no interest to the corporation, then the IRS will classify the interest that you are not paying as income to you. They determine the interest rate you should be subject to by the Applicable Federal Rate (AFR). Therefore, if the AFR is 4%, and you took out an interest-free loan of $100,000, then you will be required to pay taxes on the $4,000 that you should be paying in interest. Confusing, I know, but it is a great way to get large amounts of cash without a huge tax burden. If you are buying a home and wish for your corporation cash-cow to finance the purchase, then you are in luck. Because you can deduct the interest on your home, your corporation can give you an interest free loan and you will be free from paying any taxes. In other words, your Corporation can finance the purchase of your home without triggering a taxable event. This is called "phantom interest".

Always make sure that when you are loaning yourself money, you put everything in writing and make it official. Even document the loan in the corporate minutes. This is vital in substantiating that your loan is legitimate and not a ploy to circumvent double taxation.

Lease your goods and equipment If you have assets that the company can use for business purposes, you are in a great position! Leasing assets to your corporation is a widely accepted business practice and is a very legitimate way to transfer money to yourself without having an overwhelming tax burden.

When leasing assets to your business, make sure to do the transaction through an LLC or an S-Corporation. This way, you are not personally exposed to liability that the asset may incur while being used on behalf of your business. To form an entity for this purpose, go to MyLLC.com® or call 888-88-MYLLC.