When Congress created the Code they wanted to aid small business by reducing the overall tax burden. So several different tools were implemented to reduce or eliminate double taxation in small business. These tools include using the ‘S’ Corporation status, taking advantage of the partnership form of taxation, exercising Section 179 depreciation and/or using the cash method of accounting.
Even without these tools, a well planned financial operation under the corporate classification can reduce the overall combined income tax to a comparable level of tax incurred by the use of the above tools.
The following sections explain in more detail the respective tools and how planning can be an effective tax reduction program.
‘S’ Corporation Status
By far, this is the number one tool used by small business to eliminate double taxation. An entire section of the Internal Revenue Code is dedicated to this sole purpose. The fundamental concept is that under this tax status, the business is not taxed for income tax purposes and most states follow suite.
Any income earned is assigned to the owners (shareholders) via Form K-1. In addition, other tax attributes are passed through the corporation to the respective shareholders based on their percentage of ownership. The pass-through attributes include:
- Dividends Earned
- Interest Earned
- Capital Gains (All Forms)
- Specialized Income
- Charitable Giving
- Section 179 Deductions
- Specialized Deductions
Pass-Through means that these items are treated as individual items for tax purposes and have no bearing on corporate tax performance. There are some restrictions to set up the company including authorization by all shareholders. They are acknowledging their individual responsibility to pay their respective share of all taxes associated with the various forms of income assigned by the company. In addition, there are limitations in what owners and management can do in operating the company. For more information read: S-Corporations.
At the end of the calendar year, any net income is assigned (passed through the company) to each shareholder as if the shareholder earned the money directly. Thus the company does not pay income taxes. The individual owners pay the tax at their income tax rate.
With the ‘C’ Corporation, any dividends (dividends is the term used with C-Corporations; Distributions is the term used with S-Corporations) paid are assigned to the shareholder and then that shareholder pays income tax (the second tier of tax) on that dividend income. S-Corporations do not pay dividends, they issue distributions (payments to shareholders for their respective share of earnings). Since the money paid out has already been taxed at the individual level via the assignment from the K-1, the distributions have what is referred to as basis; therefore any distribution issued is tax free.
Partnership Form of Taxation
Another excellent tool to eliminate double taxation is the partnership form of IRS status. Unlike the S-Corporation which requires equal treatment and assignment of income based on ownership percentage, treatment and income assignment is flexible based on the terms of the partnership agreement. There are less restrictions, but the taxation is very similar to an S-Corporation as income and certain tax attributes are passed through to the partners.
There are some differences between the S-Corporation and Partnerships as follows:
- S-Corporations may be owned by one investor; partnerships must have at least two entities (individuals, corporations and/or trusts) as owners.
- S-Corporations file Form 1120-S; partnerships file Form 1065.
- Partnerships must track basis in their capital accounts.
- Partnerships may assign more compensation to a partner via guaranteed payments.
- Partnerships issue draws; S-Corporations pay distributions when paying out profits.
There are some important business legal issues for partnerships; these are addressed by using well written partnership agreements.
Section 179 Deduction
A third tool is called Section 179. It is accelerated depreciation and significantly reduces overall taxable income for small business; no matter which tax entity status is selected. This is best utilized by fast growing businesses requiring significant capital investment for fixed assets. This Internal Revenue Code section allows all forms of small business a special one time deduction for depreciation known as Section 179. The best part is that this deduction exists anew each calendar year for any new fixed asset purchases.
If you are not familiar with depreciation, please read the following articles for expanded knowledge:
- Depreciation – This is Weird Accounting
- Accelerated Depreciation
- Introduction to Depreciation (Lesson 50)
- Depreciation Schedules (Lesson 51)
- Book and Tax Depreciation (Lesson 52)
Cash Method of Accounting
A fourth tool available to small business is the cash method of accounting. Since most growing operations expand their accounts receivable, the accrual method of income is usually greater than the cash earnings. To reduce the effect of taxation, Congress allows all small businesses the privilege to elect the cash basis of reporting their net income. In some cases, this significantly reduces overall taxable income. Therefore the income tax is also reduced.
Planning for Income Taxes
Even if the entity is a traditional ‘C’ Corporation double taxation can be easily eliminated or greatly curtailed. Management can do this through good planning. This includes using the following tools:
- Section 179 Depreciation
- Accelerated Depreciation
- Bonus Depreciation
- Cash Method of Accounting
- Proper Capital Investment for Long-Term Gains
- Increased Ownership Compensation
- Creating a Legacy (Family Planning)
- Key Man Insurance
- Step-Up in Basis
All of these alternatives are explained in other articles. For the purpose of this article, owners (shareholders) just need to understand that the second tier of taxation only happens if dividends are either actively or constructively paid. Small businesses are constantly growing and retention of earnings funds this growth. Without payment of dividends, there is no second tier of taxation. When owners desire more personal income, they simply increase their compensation package. Any increase in payroll is a deduction for the corporation. Again only one layer of taxation occurs; it is paid at the individual level via personal income tax. In effect the retention of earnings are recouped when the stock is sold one day. Since the sale of stock is a capital issue, the tax assigned on the gain is assessed at capital gain rates and not ordinary income tax rates as dividends are taxed.
Summary – Double Taxation
Double taxation exists at the corporate level of entity status. Any profit earned is taxed for income tax purposes at the corporate tax rate and is taxed again at the individual level when dividends are paid. Congress has eliminated this double taxation effect with small business by authorizing special code sections. This includes:
- S-Corporation Status – Allows pass-through of taxable income to individual shareholders
- Partnership Taxation – An alternative to S-Corporation status
- Section 179 Deduction – A form of accelerated depreciation
- Cash Method of Accounting – Reduces accrual income to a lower amount for tax purposes
In addition, planning by owners and management can greatly reduce corporate income taxes.
Even if the small business is classified as a C-Corporation there are other mechanisms that can greatly reduce double taxation. Specifically, eliminating the payment of dividends, i.e. do not pay out earnings to the owners. In effect, retention of earnings for growth purposes voids the second tier of taxation. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.