Eliminating Double Taxation

The way corporations are taxed provides some interesting and challenging planning decisions. A corporation is a taxpaying entity. That is, it must file an annual tax return and pay taxes on its income. If those earnings are distributed to a shareholder, this distribution is treated as a dividend, which is then taxable to the shareholder. The effect of this is that corporate earnings are taxed twice—once at the corporate level and once at the shareholder level, when the earnings are distributed in the form of dividends.

The problem of double taxation may be eliminated in one of two ways. First, the corporation can pay out as salary an amount equal to its net earnings. This is called zeroing out the corporation. As an example, a medical corporation might have a profit of $100,000. If this amount is paid to one or more of the officers of the corporation as compensation for services, the corporation will get a tax deduction for this $100,000 in salary. That will reduce taxable income to zero, and no federal income taxes would be due. The $100,000 is included in income, and the tax is paid by the recipient. This eliminates the problem of double taxation.

The Internal Revenue Code imposes certain limitations on this technique by allowing a deduction to the corporation, only if the amount of compensation paid to a particular individual is "reasonable." The salary cannot be excessive based upon the actual services provided by the individual. There have been thousands of cases litigated by the Internal Revenue Service on this issue, and no firm rule has developed. Basically, if the salary is comparable to that received by others in similar businesses, it is unlikely that there will be a challenge from the IRS.

If you attempt to pay salary to your children or your grandmother without any services performed by them, the deduction could be disallowed as unreasonable. If the salary is disallowed as unreasonable, this amount is added back to the corporation’s income and a tax is assessed on this income. Also, the amount which was distributed is treated as a dividend to the recipient and is taxable to that individual. This produces a double tax on the same income and is clearly a disastrous result.