One of the factors a small business owner has to take into consideration when deciding if they want to operate as a sole proprietorship or partnership, or whether they should form a corporation or LLC, is the tax consequences of their choice. Sole proprietorships, partnerships, corporations, and LLCs are taxed differently under the Internal Revenue Code.
One of the main tax differences involves whether the income of the sole proprietorship, partnership, corporation, or LLC will be subject to double taxation. It’s therefore important for small business owners to understand what double taxation is because it affects both choice of entity type and how they want their chosen entity type to be taxed.
What is double taxation?
Double taxation means that the income of the business is taxed twice. Most commonly this occurs when the business entity is taxed under Subchapter C of the Internal Revenue Code. Entities taxed under Subchapter C of the Internal Revenue Code pay federal income taxes at the corporate level. If they distribute their income to their owners, their owners then pay federal income taxes at the personal income tax level.
What entities are subject to double taxation?
C corporations - Corporations, by default, are taxed under Subchapter C and are subject to double taxation. These corporations are called C corporations.
Non-corporate entities that elect to be taxed like a C corporation - An LLC or partnership, by default is not subject to double taxation. However, LLCs and partnerships can elect to be taxed under Subchapter C. If an LLC or partnership elects to be taxed like a C corporation it will be subject to double taxation.
What is pass-through taxation?
Pass-through taxation means that the entity itself – whether it is a corporation, LLC, or partnership – does not pay income taxes at the corporate income tax level. Instead, its income passes through to it shareholders, members, or partners, who pay taxes on the income at their personal income tax rate.
What entities are pass-through entities
S corporations – Corporations that qualify for taxation under Subchapter S of the Internal Revenue Code and whose shareholders elect to be taxed under Subchapter S (called S corporations) are pass-through entities and are not subject to double taxation.
LLCs and partnerships – Multi-member LLCs and partnerships, by default, are pass-through entities and are not subject to double taxation.
How are single member LLCs and sole proprietorships taxed?
Single member LLCs and sole proprietorships are “disregarded” for income tax purposes. The business’ income is considered the member’s or sole proprietor’s income. There is no double taxation.
Is double taxation always a disadvantage?
In general, yes, double taxation is a disadvantage. It will result in higher taxes than pass-through taxation in almost all situations.
Are there reasons why a small business owner would ever choose a C corporation or an LLC taxed as a C corporation?
Yes. There are advantages to choosing a C corporation or having an LLC taxed under Subchapter C, that can outweigh the disadvantages of double taxation under certain circumstances.
For example:
- In a C corporation, retained earnings are taxed only at the corporate level. With pass-through taxation, all profits are taxed at the owner level, even if not distributed. That makes C corporation taxation a possible advantage if earnings will be reinvested and not distributed to the owners.
- Employee benefits and compensation are fully deductible by entities taxed as a C corporation. Deductions are generally limited to ordinary and necessary business expenses for pass-through entities.
- Entities taxed as a C corporation can generally provide fringe benefits without triggering taxable income easier than pass through entities.
- C corporation taxation provides self employment tax savings.
- Some outside investors such as hedge funds or private equity funds will only invest in entities taxed under Subchapter C because they do not want the income passed through to them.
- Under Sec. 1202 of the Internal Revenue Code, when shareholders sell Qualified Small Business Stock (QSBS) that they’ve held for the required period they can exclude a significant portion, sometimes up to 100%, of their capital gains from the federal income tax. This is a significant tax benefit available to domestic entities taxed as a C corporation. There are several requirements that have to be met and a tax professional should be consulted by any small business owner who thinks this may be available to them.
Conclusion
Small business owners need to understand what double taxation is, whether they should avoid it, and how they can avoid it. Getting the advice of a legal or tax professional is always a good idea when making tax-related choices.