Choosing a Business Entity: Understanding Double Taxation v. Pass-through Taxation
When forming a business, an important thing to consider is how profits will be taxed. Different corporate structures have different tax consequences. “Double taxation” refers to situations where corporate profits are taxed and the corporation’s shareholders are personally taxed upon receiving dividends or distributions of those profits.
“Pass-through taxation” refers to situations where income “passes through” to investors or owners. Common types of pass-through entities are limited liability companies, limited liability partnerships, and S corporations. The partnership or company itself is not directly taxed; however, the income of the partnership is taxed, and these taxes are passed through to each partner according to their ownership interest, regardless of whether that partner actually received a distribution (i.e. money in their pocket) or not. This is what is meant by the “pass-through” process. Similarly, if the partnership took a loss for the year, each partner can deduct their share of that loss from their personal tax return. A pass-through entity is still required to file a tax return, even without a tax burden. The annual return reports the shares of income allocated to owners, and provide each owner with a statement of allocated income to enable owners to report their shares of income on their own tax returns. In the United States, this is the Schedule K-1.
To illustrate the basic differences between the two types of taxation, imagine two corporations. For the purposes of this illustration, we will assume that each corporation has a single owner/shareholder—Person A. Each company earns the same pretax profit of $100,000. The first company is a C-Corporation and is subject to double taxation, meaning it first pays corporate income taxes (assume $22,500), then distributes the remaining profit ($77,500) to the owners as a dividend who pay personal income taxes on the $77,500. In this case, since A is the sole owner, A would then pay personal income on $77,500 at the applicable rate.
Now imagine A’s company is a pass-through entity (such as an LLC or S-Corporation). Pass-through taxation can still apply to single-owner entities. A would not pay corporate income tax. The pass-through corporation can distribute the entire $100,000 in profits to A as dividends. A would pay personal income taxes on $100,000 at the applicable rate. If A is in the 35-percent tax bracket, A will net $65,000 in after-tax profits from the pass-through entity.
Criticisms of the Double Taxation
“Double taxation” sometimes has negative connotations because many construe it as a penalty against owner-shareholders. They have fewer ‘take-home’ dollars because every dollar earned is taxed twice.
However, others argue under the theory of corporate personhood, that a corporation is separate from its shareholders. As a separate entity, a corporation has the right to use public goods as an individual does, and it should help pay for the public goods consumed through its taxes. Another argument in favor of this method of taxation is that corporations’ owners enjoy limited liability, and that the price of this protection is the corporate tax.
Over the years, there have also been criticism of dividend taxation. Many argue that since the profits have been taxed at the corporate level, they profits should not also be taxed when paid out to the shareholders as dividends.
Criticisms of the Pass-through Taxation
“Pass-through” taxation can result in higher taxes depending on the nature of the business, its economic structure, and how the partners intend to raise financing.
If you intend to raise financing through outside investors, it’s often a deal-breaker for investors if your business is set up as a pass-through entity. Investors tend to dislike Schedule K-1s and being taxed on the entity’s income even though no cash has been distributed to them to pay their taxes.
Furthermore, some investors, e.g. venture funds, cannot invest in pass-through entities because they have tax-exempt partners that do not want to receive active business income because of their tax-exempt status.
Last, many critics believe the pass-through structure makes it difficult for companies to reinvest capital in the business. Since pass-through entities generally have provisions in their company agreement detailing the process for how and when cash will be distributed to owners to cover their taxes that they owe on the company’s income, it is difficult to withhold enough cash necessary to grow the business.
Which method is better?
There is not a one-size-fits-all answer to determine which corporate entity is better. It depends on each company’s specific situation.
Smaller businesses often prefer pass-through taxation because the final tax burden may be less than it would be with double taxation. It is often easier to administrate because the record keeping requirement is simpler (annual meetings and minutes are not required). Additional advantages to pass-through companies (such as LLCs) include:
- Members of the LLC can usually make contributions to the LLC at any time without tax consequences.
- Pass-through taxation through an LLC also provides tax flexibility and presents some opportunities for tax planning among members. It is also important to remember that there are differences within the different types of pass-through entities. This is an incredibly complex area and you should consult with your tax attorney or accountant.
However, in some situations, a business may prefer corporate taxation (becoming a double-taxed entity) because it allows the company to retain earnings to reinvest in the company, and may result in a lower personal income tax burden for the owner(s).
Thank you to Danielle Flatt for her significant contributions to this blog post.