Taxes are tedious and confusing if you don’t know what you’re doing. Legal entities like startups and other businesses are all required to pay taxes. This can get more complicated, as the IRS may or may not require you to pay your taxes twice, depending on your business structure of choice.
The double taxation policy requires businesses to pay their taxes twice on the same income. This policy will often apply to startups structured as corporations, international trades or investments, and traditional IRAs.
Luckily, LLCs who want to avoid double taxation can adopt various strategies to work around it. But before you look into how to prevent multiple taxes, you need to determine if the rule applies to your startup.
This blog discusses how double taxation works, explores whether LLCs are double taxed, and how businesses can avoid them.
How Double Taxation Works
Corporations, like any other business entity, must pay their taxes at the end of every fiscal year. Since owners are legally considered separate from their shareholders, they are taxed depending on their annual income.
But, if their earnings are distributed, the company’s shareholders must pay their taxes depending on their shares. An example of this would be the following:
Suppose a store earns $850,000 during the 2021 fiscal year and distributes $350,000 to its shareholders. They would have to pay $178,500 in taxes. Their shareholders will also be required to pay another set of taxes depending on their respective shares.
Additionally, there are two categories of double taxation: corporate and international double taxation agreements.
Corporate double taxation involves taxing business earnings twice on two different levels: corporate and dividend tax. This policy is common in the US and other countries.
Meanwhile, international double taxation mainly applies to multinational entities that operate outside the jurisdictions of their home country. In certain instances, it can also affect the foreign income of individuals in other countries.
Do LLCs Have Double Taxation?
Fortunately, LLCs are not double-taxed. Startups structured as C corporations are the only entities that have to pay their taxes twice. S corporations and sole proprietors can also avoid double taxation.
Unlike C corporations, LLCs and sole proprietors are legally considered pass-through entities. The structure means their earnings go directly to their owners, who pay their taxes through their personal income tax.
Another way you can avoid double taxation is by adopting the S corporation structure. Like LLCs, S corps are not required to pay their taxes twice. Instead, the IRS taxes them in the same way they tax partnerships.
Ultimately, if you want to structure your venture as an LLC, you don’t have to avoid double taxation anymore, as you won’t be taxed twice by default.
Seven Ways to Avoid Double Taxation
The easiest way to avoid or minimize double taxation is to steer clear of the C corp structure. But if the structure is appropriate for your startup, you can implement other strategies to legally avoid being double-taxed.
Place Income Into Retained Earnings
If your business is relatively small, we recommend placing your income into retained earnings instead of paying shares to your shareholders.
By using this strategy, you can rest easy knowing that your earnings are only taxed at the corporate level. You can also use retained earnings to fund future expansions of your startup.
Suppose you and your shareholders depend on your company’s profit for income. If so, the only way you can receive shares without paying your taxes twice is to become an employee.
Salaries are considered deductible expenses for a company. Still, they can be taxed at a personal rate, removing the need for double taxation. So instead of dividing your profit into shares and allocating them to your shareholders, you can pay them off as salaries.
Set up A Separate Pass-through Entity
Creating a separate flow-through entity, like an LLC, is one of the more tedious processes to avoid paying your taxes twice. This method is an effective strategy to get more out of your business structure.
If you build another LLC, you can use this venture to buy properties and equipment to lease to your main company. Besides helping your corporation avoid double taxes, it creates another source of income for your LLC and a deduction for your company.
Elect S Corporation Tax Status
Another effective way to avoid being double taxed is by applying for an S corp tax status.
The IRS grants certain companies S corp tax status since the two entities have the same advantages of limited liability. The only difference is that S corps avoids being double taxed by directing their profit to their shareholders.
You can still apply for an S corp election. But remember that switching to this status means having limited shareholders.
Take Out A Loan
The IRS won’t treat loans as taxable shares if you decide to take them out of your business. This strategy is a great option for those that don’t have to pay several shareholders.
Keep in mind that the IRS will likely inspect the loan. They’ll check to see if the transaction is not disguised as a dividend and ensure that you’re paying your loans back with a justifiable interest rate.
You can lessen your company’s double tax obligation by splitting its annual profits by allocating a percentage of your earnings and reinvesting it in your business. You can also hire more people to expand your team and draw additional salaries.
This approach doesn’t prevent your venture from being double-taxed, but it can help lessen your obligations.
Search For Double Taxation Agreements (DTA)
The last approach we recommend is for companies impacted by international double taxation. Double taxation agreements (DTA) are treaties approved by two countries to prevent or lessen territorial double taxes.
DTAs are placed to encourage international trade and help alleviate multinational ventures from being double taxed. Typically, the agreement requires tax to be charged in one country and exempt in another.
For instance, Australian shareholders of an American venture are required to pay their taxes in their home country and are exempted from paying taxes in the US.
On the other hand, some shareholders are imposed to pay taxes in the country where the profit is generated and will be given foreign tax credits in their homeland.
Navigate Your Taxes With Ease & Avoid Double Taxation
Undeniably, there’s only so much a C corp can do to avoid being double-taxed. The most effective way a business can protect itself from this is by restructuring the business for an advantage.
NCH’s business formation specialists will help you explore various business structures and determine the right alternative for your startup. Our team of tax specialists can also provide a helping hand in understanding international double taxation policies.