Small Business Tax: How to Avoid Double Taxation of Your Small Business Profits

The advantages of incorporating your small business are many.

For starters, you and your family will be protected from the possibility of a lawsuit that ends your business. Forming a corporation is the first step 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, incorporation has both advantages and disadvantages. Yes, forming a corporation can lower your taxes or increase your taxes, depending on the type of corporation you create.

There are two main types of corporations: “C” corporations and “S” corporations, and the type you choose can make a difference in the tax world.

NOTE: The “C” Corp vs. “S” Corp has no effect on the asset protection provided by your corporation. This is a tax problem, not a legal problem.

A “C” corporation can lead you into a tax trap known as “double taxation.” Yes, the income of a “C” corporation can actually be taxed twice: once when it is earned at the corporate level and once when it is 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” corporation rather than a “C” corporation. The profits of an “S” corporation are not taxable for the corporation; instead, those gains 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 Entity Choice article must contain the old disclaimer, “Consult your tax professional.” I am not prescribing a one-size-fits-all approach to this topic. But for many small business owners and self-employed individuals, the “S” Corporation is a good choice because it provides protection against personal liability and avoids the nasty double taxation tax trap – two big benefits worth checking out. .

If you incorporate your sole proprietorship and later decide that the “S” Corporation is appropriate, 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 a an “S” Corporation.

IMPORTANT: If you join and do not file Form 2553, the IRS automatically considers you a “C” Corporation. In other words, to be a “C” Corporation, you simply join; there is nothing you need to do to inform the IRS that you want to be a “C” corporation.

There are critical rules about how and when to file Form 2553, so be sure to read the instructions carefully or check with your tax professional.

Failure to file Form 2553 on time or filing Form 2553 incorrectly results in the rejection of your corporation’s application for Corporation “S”, and the corporation is treated by default as a Corporation “C”, subject to double taxation, the same trap that you were trying to avoid.