Small Business Taxes – How to Avoid Double Taxation of Your Small Business Profits
The advantages are incorporating your small business are many.
For starters, you’ll be protecting yourself and your family from the possibility of a business ending lawsuit. Forming a corporation is Step One on the path known as “Asset Protection” — you are moving from the world of unlimited liability to the world of limited liability.
From a tax standpoint, there are both advantages and disadvantages to incorporating. Yes, forming a corporation can either reduce your taxes or increase your taxes, depending on what type of corporation you create.
There are two main types of corporations: “C” Corporations and “S” Corporations — and which type you choose can make all the difference in the world of taxes.
NOTE: The question of “C” Corp vs. “S” Corp has no effect on the asset protection provided by your corporation. This is a tax issue, not a legal issue.
A “C” Corporation can lead you into a Tax Trap known as “double taxation”. Yes, income from a “C” Corporation can actually be taxed twice — once when it’s earned on the corporate level and again when it’s paid to you, the shareholder, in dividends.
There are several ways to avoid double taxation. Often the easiest way is to tell the IRS that you choose to be an “S” Corp instead of a “C” Corp. The profits of an “S” Corp are not taxable to the corporation; instead, those profits are reported directly on the shareholder’s personal income tax return and are therefore only taxed once.
And once is enough, don’t you think?
Of course, any article on Choice of Entity must contain the old disclaimer, “Consult your tax professional” — I am not prescribing a one-size-fits-all approach to this issue. But for many small biz owners and self-employed folks, the “S” Corporation is a good fit because it provides protection from personal liability and avoids the nasty tax trap of double taxation — two great benefits worth checking into.
Should you incorporate your sole proprietorship and then decide that the “S” Corporation is the right fit, you must inform the IRS that your corporation is choosing “S” Corporation status by filing Form 2553, which is, in effect, an application to become an “S” Corporation.
IMPORTANT: If you incorporate and do not file Form 2553, you are automatically considered to be a “C” Corporation by the IRS. In other words, to be a “C” Corporation, you just incorporate; there is nothing you have to do to inform the IRS you want to be a “C” Corporation.
There are critical rules regarding how and when to file Form 2553, so be sure to read the instructions carefully, or check with your tax pro.
Failure to file Form 2553 on time or filing Form 2553 incorrectly results in a rejection of your corporation’s “S” Corp application, and the corporation is then by default treated as a “C” Corp, subject to double taxation, the very trap you were trying to avoid.