How to Avoid Double Taxation for Small Corporations

May 29, 2012

One of the first decisions new San Diego business owners make is whether or not to incorporate or form some other formal business entity. The decision often seems daunting and turning to a San Diego Business Lawyer and tax professional are important first steps. If the business owner opts for a limited liability company ("LLC") or an S-Corporation (which is taxed like a partnership as opposed to the C-Corporation subject to double taxation), double taxation is not an issue. Thus, the first way to avoid double taxation is to choose a business entity that is not double taxed. This includes forming a California Corporation and then electing S-Corporation status with the IRS. Many small business owners have nonetheless formed corporations without electing S-Corporation status. This may be because a tax professional recommended it or because the business owner simply didn't consider the various business entities available when forming the corporation. Whatever the reason, the choice of a C-Corporation for small businesses isn't inherently a bad one. It does, however, become imperative that these C-Corporations take steps to avoid or at least limit double taxation.

369109_taxpapers.jpgThe easiest way to avoid double taxation is to elect to be taxed as an S-Corporation with the Internal Revenue Service. However, to qualify for S-Corporation status the IRS requires that your corporation be a domestic corporation, issue only one class of stock, distribute profits and losses in proportion to shareholder interests and have no more than 100 shareholders who are natural persons and U.S. citizens. Another corporation or LLC cannot own stock in an S-Corporation nor can foreign nationals. If opting for S-Corporation taxation, it is important to timely file Form 2553 with the IRS - no later than the 15th day of the third month following the date of incorporation. If a business is already incorporated, it can still opt for S-Corporation taxation the following year by filing Form 2553 by December 31st. However, it's important to consult with a tax professional before doing so especially where the company was initially advised not to elect S-Corporation status.

If you are a small corporation and do not elect S-Corporation status, the following is a short list of legitimate ways to minimize double taxation:

Accumulate Earnings: Leaving profits in the corporation avoids double taxation since there are no dividends to tax. Saving is advantageous so long as the money is eventually re-invested toward growth. It is a good short term plan. However, if too much profit is retained, the corporation can face an additional Accumulated Earnings Tax (a substantial penalty in addition to the regular corporate tax). The goal is to prevent corporations from accumulating profits for the sole purpose of avoiding income tax. The IRS looks to see if the corporation is accumulating earnings and profits beyond the reasonable needs of the business. Generally, accumulated earnings up to $250,000 ($150,000 for some personal service corporations) are considered reasonable. For earnings in excess of this amount, corporations may still show the IRS that the retained earnings are reasonable based on the needs of the business. If you choose to retain earnings, consult with your tax professional.

Pay Owners a Salary:  Owners who are officers, directors or employees of the corporation are allowed to take a salary.  While the personal income is taxable to the owner, the corporate entity gets to write off the salary expense reducing the overall tax.  This is by far the best way for small corporations to avoid double taxation so long as the owners can actually justify their salaries.  Active managers and hands on corporate officers who play a critical role in the day-to-day operations of the business can easily justify their incomes (so long as income levels are reasonable).  Passive owners that appear once a year at a shareholder's meeting, on the other hand, would have a hard time justifying high salaries.  Whether a salary is reasonable depends on how the salary compares to the salary for similar positions in competing businesses, the time dedicated to the position, the owner's salary history and whether the salary is in line with the company's economics.  Note that the IRS is suspicious of bonuses.  However, the IRS will allow a bonus if it can be supported (by the acquisition of a large account or by reaching a pre-set revenue figure for example).  Otherwise, the IRS might see the bonus as a disguised dividend.  In addition, owner employees may receive employee benefits which are deductible expenses for the corporation.  Finally, passive owners can be paid consultant fees.  Consultant fees are considered tax deductable expenses.  Like owner employees, the passive owner consultant still needs to pay taxes on the compensation as income.  Shareholders can also receive income serving on the board of directors.

Put Family Members on the Payroll:   As long as family members are legitimate employees taking a reasonable salary, it is legal to keep them on the payroll.  This is especially beneficial where corporate profits are too high to absorb the owners' reasonable incomes. Moreover, so long as you adhere to child labor laws you can pay your children for doing odd jobs.  Paying owners less and bringing family members on board can offer the additional advantage of keeping owners' in a lower tax bracket.  

Borrow from the Corporation:  When an owner borrows money from the corporation it is not a dividend subject to taxation.  It allows the owner to use corporate money without creating a large tax liability.  The owner still has to pay the money back with a reasonable interest rate or the IRS will consider it a dividend.