Question

One of the disadvantages of the corporation is double taxation. Discuss the concept along with an example. How do corporate taxes differ from personal tax liability and what are the tax implications for multinational corporations? You may also consider the implications of state vs. federal taxation, transfer pricing, the recent Wayfair decision, and/or pass-through entities in your answer.

Answer 1

Corporations offer a business many advantages, but there are also disadvantages that must be considered. These include loss of control of the business as it moves from privately owned to publicly owned; double taxation if the business is a C corporation; state-required filing fees, written bylaws, and various documents; and determination of and adherence to applicable rules and regulations. These disadvantages are discussed in greater detail below.

Double Taxation

Another disadvantage of forming a corporation is the double taxation requirement. C corporations pay taxes on profits when corporate income is distributed to owners (shareholders) in the form of dividends. This is the first taxation.

The shareholders who receive dividends must also pay taxes for this distribution on their personal returns. This is the second taxation of the same money.

The corporation itself does not pay taxes twice, but just the sound of “double taxation” can make potential business owners cringe. However, there is another option. Choose the Internal Revenue Service (IRS) "S Corporation" tax status to avoid double taxation.

Corporate tax is an expense of a business (cash outflow) levied by the government that represents a country’s main source of income, whereas personal income tax is a type of tax governmentally imposed on an individual’s income, such as wages and salaries.

• Corporate tax is a direct tax paid by businesses to the government on their earnings. The funds collected from the taxes serve as a country’s source of income and are directed to financing various projects for the benefit of its citizens.
• The maximum corporate tax rate equal to 35%.
• Personal income tax is a direct tax paid by individuals to the government on their personal income coming from monthly salaries and wages.

Under the federal tax system, taxpayers can claim either a standard deduction or itemize their deductions. Standard deductions increased considerably in 2018 under the TCJA, making it more advantageous for many taxpayers simply to take the that deduction. For the 2020 tax year, the standard deduction is $12,400 for single taxpayers, $18,650 for head of household filers, and $24,800 for married couples filing jointly.2

As mentioned above, states and the federal government differ in terms of the types of income they tax and the deductions and credits they allow. For example, pension and Social Security income are taxable under the federal rules, while a number of states exempt it from taxation. Income from U.S. Treasury securities, including savings bonds, is exempt from state tax, but subject to federal taxes.

EXAMPLE

Consider a single taxpayer who lives in New Hampshire and reports a taxable earned income of $75,000 a year plus interest income of $3,000 on their federal tax return. They would pay just $150 in state taxes because New Hampshire doesn't tax earned income but does tax investment income at the rate of 5%. Their effective state tax rate on their total income of $78,000 (tax obligation divided by taxable income) would be 0.2%.

If this same person lived in Illinois, however, all of their taxable income, both earned and unearned, would be subject to that state's 4.95% flat tax rate. In that case, their tax bill would be $3,861.

In terms of federal taxes, under the progressive system they would pay $988 on the first $9,875 of their income, which falls into the 10% tax bracket, as of 2020. They'd pay 12% on their income from $9,876 to $40,125 ($3,630) and 22% on the balance ($8,332) for a total federal tax bill of $12,950. Their effective federal tax rate would be 16.7%.