Single vs. Double Taxation By Leon Presser- author of What it Takes to become an Entrepreneur You should be aware of the difference between single and double taxation. One of the first legal decisions you will need to make as an entrepreneur is how you are going to operate as a business. That is, are you going to operate as sole proprietorship, as a partnership, as a corporation, as a limited liability company, …? This decision has legal, tax and operational implications. In this note I am going to address only one issue but an important one. The issue is the amount of tax you will be required to pay. With some legal entities you incur single taxation, while with others you are subject to double taxation. For example, with an S corporation or a limited liability company (LLC) you will not pay double taxes while with a C corporation you will. Let me illustrate with a quantitative example. For Federal income tax purposes the following rates are currently in place: 1. C corporations are taxed at a maximum tax rate of 35%. 2. Dividend distributions by a C corporation to its shareholders are taxed at a maximum tax rate of 15%. 3. Individuals are taxed at a maximum tax rate of 35%.
A C corporation pays income tax on its income at the corporate tax rate. The Board of Directors of the corporation decides on whether or not dividends are paid to its shareholders, and if they are paid, the Board decides the amount and the timing. The corporation’s shareholders pay income tax on any corporate dividends they receive at the individual tax rate on their personal income. This is referred to as double taxation. In the case of an S corporation or an LLC any profits (losses) achieved by the S corporation or the LLC are passed through to the individual shareholders who will include them in their personal tax returns. Thus, any monies going to the individual shareholders are taxed only once, as part of their personal tax return. This is referred to as single taxation. Let’s look at some specific numbers to grasp the importance of the topic. If your earnings came through a C corporation, the effective tax rate on the earnings distributed to you personally was 44.75%. This tax rate was computed as follows: the income of the C corporation was taxed at 35%; the money remaining after the 35% tax was deducted then taxed again at 15% when it was distributed to you as dividends; and the result is that you net approximately 55.25% (i.e., 100% -44.75%) of the monies originally earned by the C corporation. That is double taxation! Now, suppose that your earnings were coming through an S corporation or an LLC instead of a C corporation.
The earnings would pass through to you and be taxed as individual income at 35%. The result is that you would net 65% of the monies originally earned by the S corporation or the LLC. This is single taxation! Note that with the S corporation or the LLC, you keep 9.75% more of the money originally earned (i.e., 44.75% – 35%). Please realize that in this example I computed taxes based only on federal tax rates. In addition, you would have to pay applicable state and employment-related taxes. Thus, the tax bite is even larger. The maximum 15% federal tax rate on the distribution of dividends is scheduled to expire in 2010. Congress is discussing changes to this tax rate as well as others. You should realize that changes in these tax rates can have a serious impact in your ability to succeed as an entrepreneur. Further, you need to evaluate carefully any changes to any of these tax rates to make certain that the way you are operating your business is still the best way. I want to emphasize that your decision in selecting a form of legal entity to operate your business must be made taking into consideration a number of important issues. In this note we addressed only one of those issues: single vs. double taxation. You can not make your decision on this issue alone. Of course, I must tell you that I do cover this topic and related issues in more detail in the book. I do want you to read the book. I also encourage you to go to the book’s website (www.whatittakestobeanentrepreneur.com) and subscribe so that you will be notified each time a new post occurs.