This is a common question for small business owners and entrepreneurs. The short answer is yes, business owners often do pay taxes twice on their business income. However, with proper tax planning, it is possible to reduce or eliminate the double taxation.
What is Double Taxation?
Double taxation refers to being taxed twice on the same source of income. For business owners, this happens because businesses are subject to income tax at the corporate level, and then business owners pay personal income taxes on the profits they receive from the business.
For example, imagine a small business earns $100,000 in profits. The business pays corporate income tax on the $100,000, reducing the profit to $65,000. When the owner receives the remaining $65,000 as a distribution, they must report that as personal income on their individual tax return and pay personal income tax on it.
So the original $100,000 business profit gets taxed twice – once at the corporate level and again at the personal level.
What Types of Businesses Get Double Taxed?
Most business structures face the issue of double taxation except for:
- Sole proprietorships
- Partnerships
- S-corporations (if certain requirements are met)
Here is a breakdown of how common business structures are taxed:
Sole Proprietorships and Partnerships
Sole proprietors and partnerships do not pay income tax at the business level. The profit or loss from the business “passes through” and is reported directly on the owner’s personal tax return. So there is no double taxation.
C-Corporations
C-corporations pay corporate income tax on net profits. When profits are distributed to owners as dividends, those dividends get taxed again at the personal level. This leads to full double taxation.
S-Corporations
S-corporations avoid double taxation if shareholders are paid “reasonable compensation.” Reasonable compensation is subject to payroll taxes but not income tax at the corporate level. Any remaining profits are passed onto owners and taxed only at the personal level.
Limited Liability Companies (LLCs)
LLCs are not actually taxed themselves. An LLC can choose to be taxed as a C-corp, S-corp, partnership, or sole proprietorship. So double taxation depends on the LLC’s tax status.
Ways Business Owners Reduce Double Taxation
While double taxation is often unavoidable, there are some strategies business owners can use to reduce the impact:
Choose an S-Corporation Structure
Electing S-corp status avoids double taxation on profits passed to owners. The catch is shareholders must pay themselves “reasonable compensation” subject to payroll taxes.
Pay Owners a Salary
For C-corps and LLCs taxed as C-corps, pay owners/shareholders a salary instead of taking all distributions. Salaries are deductible business expenses that reduce taxable corporate income.
Make Tax-Deductible Expenses
Maximize business expenses, contributions to retirement plans, and other deductible expenses to reduce corporate taxable income.
Use Tax-Deferred Retirement Plans
Contributing pre-tax profits to retirement plans like 401(k)s or SEP IRAs can reduce taxable corporate income.
Carry Forward Business Losses
If your business loses money, those losses can be used to offset future corporate income for several years.
Talk to Your Accountant
Discuss your situation with a tax professional to identify other legal deductions, credits, and strategies to minimize double taxation.
Frequently Asked Questions
Do LLC owners pay double taxation?
LLCs themselves do not pay taxes. LLC owners pay taxes based on how the business elects to be taxed. If taxed as an S-corp, double taxation can be avoided. If taxed as a C-corp, LLC owners face double taxation.
Do small business owners pay more taxes?
Small business owners often pay more taxes due to double taxation on business profits. However, there are many deductions and strategies available to reduce taxes for small business owners.
Is it better to be a sole proprietor or LLC?
There is no clear “better” option. Sole proprietors avoid double taxation but have unlimited personal liability. LLCs provide liability protection but may face double taxation if not structured properly.
Should I pay myself a salary from my LLC?
If you have an LLC taxed as an S-corp, paying yourself a reasonable salary subject to payroll taxes can reduce double taxation. For LLCs taxed as partnerships, salaries only change how profits are allocated to owners.
The Bottom Line
Double taxation is a reality for many business owners. With proactive tax planning, business structure choices, and strategic profit distributions, it is possible to minimize the double tax burden. Working closely with accounting and tax professionals can help identify the best strategies based on your particular business situation.