Avoiding Double Taxation on C Corporations

C corporations (C corps) are often an excellent but overlooked entity choice in estate planning. With the passage of the Tax Cuts and Jobs Act, the new C corps tax rate is 21% while the top individual tax rate is 37%. To take advantage of the lower fixed rate, many of your clients may wonder if they should convert their partnerships, LLCs, or S corps into a C corps. This change in entity is specifically beneficial for clients who exceed the current income thresholds ($157,500 filing single and $315,000 filing jointly) and are unlikely to take full advantage of the 20% passthrough deduction.

However, fears of the dreaded “double taxation” may lead some to reject C corps without a closer look. But, double taxation can be decreased, and in some cases avoided, making it an option worth considering. What is double taxation, you may ask? Double taxation occurs when a business’ earned income is taxed twice; first, at a corporate level and then again at the owner’s personal level. This is because corporations must first pay corporate tax on any profits and are then subject to a second layer of tax when leftover profits are distributed to shareholders (in the form of dividends). Dividends are classified as either ordinary or qualified. Ordinary dividends are subject to the individual shareholder’s income tax rate—which could be as high as 37%—while qualified dividends are taxed at the lower capital gains rate.

Through proper tax planning, double taxation may be reduced or eliminated. If a C corp is the optimal form for your client, you can use the following strategies to reduce the effects of double taxation:

1. Splitting a business into two entities: In order to lessen the effects of double taxation, consider splitting your client’s company into two separate businesses. This works for companies that have two or more separate sources of income. For example, if a business provides consulting services as well as sells software products, those activities could be provided by different entities, each of which have a different tax structure. For example, the software products segment of the business could be organized as an LLC or S corp and subject its income to a single layer of tax under the passthrough rules. The consulting part of the business could be incorporated, and its income would be subject to the 21% corporate tax rate.
2. Retained earnings: Another way to avoid double taxation is simply to retain corporate earnings. By retaining the income rather than distributing it to shareholders as dividends, the second layer of taxation can be avoided. This is not an option for entities whose owners rely on cash flow from the corporation. But, it works well when the owners can afford to reinvest the cash in the corporation to grow the business.
3. Salary distributions: To minimize the effects of double taxation, a corporation could also distribute its income in the form of salary or bonus, rather than dividends. The salary or bonus will be taxable to the recipients, but it will also be a deductible expense for the corporation. This strategy may be more effective in a corporation whose income is primarily derived from operations. Since the company’s income is earned by the efforts of its employees, it is more difficult for the IRS to challenge the salary characterization.
4. Income splitting: Income splitting is another strategy to reduce the effects of double taxation. Income splitting occurs when business owners withdraw as much of the corporate profits as they need to support their lifestyles, but reinvest the rest in the corporation. Individuals are subject to progressive tax brackets while C corps have a flat 21% rate after the Tax Cuts and Jobs Act, so income splitting minimizes the effects of double taxation. By taking only a portion of the corporation’s profits out as salary (a deductible expense to the corporation), and leaving the rest of the profits in the corporation for reinvestment, the corporation’s collective tax burden is reduced.
5. Time dividend payments for low tax years: The effects of double taxation of corporate income can also be minimized by distributing dividends in years when a shareholders income is otherwise low. In tax year 2018, individuals who make less than $38,600 in taxable income, and married couples who make less than $77,200 in taxable income, now pay 0% taxes on qualified dividends and long-term capital gains. State taxes may still apply, depending upon where a taxpayer lives, but even in states with higher-than-average income, the federal tax-free rate remains a huge benefit.
6. Change of entity: A final method of avoiding double taxation of C corps is converting existing C corps to a passthrough entity, such as an S corp. Unlike C corps, S corps don’t have to pay corporate income tax since all income and losses are reported by the shareholder on their personal income tax returns. This is a good option for businesses who would like to stay incorporated, but wish to avoid double taxation. To qualify for S status, a corporation must meet a number of requirements, so an S corp will not be an option for many businesses.

As you can see, there is still plenty of opportunity to take advantage of the currently low corporate tax rate while minimizing the effects of double taxation. With some planning and awareness, estate and business planners can help their clients select the most advantageous choice of entity. Keep in mind that all strategies heavily depend on your client’s income, internal structure, economic objectives, and the service(s) it provides.