Avoiding Double Taxation

April 13, 2006

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When comparing the limited liability company (LLC) and the corporation, the tax implications of your decision will have an impact on how earnings and distributions are reported.

Many commentators suggest the fact that, since "double taxation" of dividends applies only in the corporation, the LLC enjoys a tax benefit over the corporation. While this is true, in practice the absence of "double taxation" of dividends in the LLC probably offers only minimal benefits.

The corporation is a separate taxpayer. It computes its taxable income before deducting or paying any dividends to shareholders. Therefore, the dividend is taxed at the corporate level. In addition, when the corporation pays a dividend (a distribution to the owners of current year earnings or accumulated earnings), the dividend is taxable to the owner upon receipt. Thus, in effect, the dividend has been taxed twice.

Let's say a corporation has taxable income of $800,000 and will pay a $100,000 dividend out of these earnings. If the corporation's tax rate is a flat 40 percent, it will pay $320,000 in taxes ($800,000 x 40 percent).

Had the corporation been able to deduct the dividend, it would have paid only $280,000 in taxes ($700,000 x 40 percent). Its taxable income would have been lowered by $100,000, and its taxes lowered by $40,000 ($100,000 x 40 percent).

Another way of looking at it is that the corporation is taxed on the $700,000 plus the dividend of $100,000. In other words, the dividend is taxed at the corporate level because it is not deductible, but it is also taxed when it received by the shareholder.

The LLC is not a separate taxpayer, and it does not pay dividends. Thus, the double taxation concept does not apply to LLCs (unless, of course, an LLC elected to be treated as corporation for federal income tax purposes, which would be a rare occurrence).

Nevertheless, in a small corporation, the owners can avoid paying dividends and instead can withdraw cash from the business in deductible ways, as salary, lease and loan payments, etc. Very large salaries for small business owners have been upheld as deductible expenses. Most small corporations, in fact, do not pay any dividends, and yet distribute all of the disposable income to the owners in this tax-deductible way.

In addition, most small corporations elect subchapter S status, which means that the corporation itself will pay no income taxes, and double taxation of dividends will not apply. Thus, for small corporations, the double tax on dividends is seldom a problem.

In short, the absence of double taxation of dividends in the LLC may not be of much benefit to the small business owner because double taxation can usually be avoided in the corporation too, through payments of salary to the owner. In this respect, the real benefit in the LLC is in not having to avoid the double taxation in the first place.