One of the major disadvantages business owners face when doing business as a corporation (AKA a “C Corporaton) is “double taxation.” A corporation is its own separate tax-paying entity. A corporation files a tax return (Form 1120) that is separate and apart from tax returns filed by its shareholders.
Double Taxation on Dividends
Corporate profits can either be re-invested in the corporation as “retained earnings” or distributed to the shareholders in proportion to their ownership interest as dividends. Payment of corporation profits to its shareholders as dividends are effectively taxed two times. First, the corporation pays taxes on the dividends as corporate profits. Then, the shareholders pay taxes on the dividends received.
At the time of this writing, dividends are taxed at capital gains rates. Shareholders in the 10% and 15% brackets pay 0%. Shareholders in higher brackets pay 15%. NOTE: these rates are set to expire in 2013 when, unless the legislature acts, higher rates will come into effect.
No Double Taxation on Other Payments
Not all payments made to shareholders are subject to double taxation. The corporation, for example, may deduct the following payments to shareholders as business expenses: reasonable salaries, reasonable rent for property leased to the business, and interest on loans made to the corporation by a shareholder.
Payments Cannot be Disguised Dividends
It must be noted that payments made to shareholders must be reasonable. Payments to shareholders are deductible only if they are reasonable business expenses. Payments that are greater than a reasonable amount may be considered dividends regardless of their label when made.
In addition to being reasonable, shareholder salaries must also be paid only to compensate the shareholder for services rendered. Even if labeled a salary, payments made to shareholders where they are not compensation for services may be viewed as a disguised dividend.
Double taxation and the risk of having shareholder payments considered disguised dividends are avoided in companies conducting business as S Corporations or Limited Liability Companies (LLCs). The profits and losses of S Corporations and LLCs are “passed through” to their owners, thus avoiding the double taxation issue.