The Internal Revenue Code classifies most businesses into one of two broad categories: Businesses that are taxed twice on their income under subchapter C of the Internal Revenue Code, and those that escape double taxation as pass-through entities. This article explains double taxation. It also identifies which businesses are subject to double taxation on their income and which escape double taxation as pass-through entities.
What is Double Taxation?
The term double taxation refers to the multiple layers of tax imposed by subchapter C of the Internal Revenue Code. Under subchapter C, all income earned by the business is taxed twice: The business pays an entity-level tax when it earns income, and the owners pay an owner-level tax when profits are distributed to the owners.
Example: The corporation earns $100,000 of taxable income. Because C corporations pay a 21-percent tax rate, it will pay $21,000 in tax on the $100,000 of income, leaving $79,000 available for distribution to shareholders as qualified dividends. When the shareholders receive the dividend, they will pay another layer of tax on the same income. Assuming the dividends are taxed as qualified dividends at a 15-percent rate, the shareholders will pay an additional tax of $11,850 on the dividend, leaving the shareholders with an after-tax profit of $67,150. The end result is that 32.85 percent of the C corporation’s income was paid out in taxes.
This double taxation makes C corporations the highest-taxed form of business.
What are Pass-Through Entities?
Businesses that are not taxed under subchapter C are called pass-through entities. The business does not pay an entity-level tax on its income. Instead, all income of the business is “passed through” to the owners, who report it on their personal income tax return and pay taxes at their effective marginal rate. Because the business does not pay an entity-level tax, pass-through entities avoid double taxation.
Example: Same facts as the example above, except that the business is an LLC taxed as a partnership. When the business earns $100,000 of income, it is not taxed on the earnings. Instead, all income is passed through to the owners, who pay tax at their effective marginal income tax rates. If all owners are in the 24-percent bracket for individuals earning 100,000, the owners will pay $24,000 in taxes—a 27 percent savings over the $32,850 they would have paid as a C corporation.
Although this example does not take all items of income and deduction into account, it illustrates the tax savings that a pass-through entity offers when compared to a C corporation.
Are LLCs Taxed as Pass-Through Entities?
LLCs are taxed as pass-through entities by default. If the LLC has only one owner (single-member LLC), the Internal Revenue Code disregards it and taxes the income directly to the owner. If the LLC has multiple owners (multiple-member LLC), the Internal Revenue Code taxes it as a partnership. In either case, the income is passed through to the owners when earned and only taxed once, on the owners’ tax returns. The LLC is not taxed separately from the owners.
LLCs can change their default classification by electing to be taxed under subchapter C or subchapter S of the Internal Revenue Code. If the LLC elects to be taxed under subchapter S (often done to save self-employment taxes), it remains a pass-through entity and its income is only taxed once. But if the LLC elects to be taxed as a C corporation, it becomes subject to double taxation and loses pass-through treatment.
What Business Entities Are Subject to Double Taxation?
Businesses entities taxed under subchapter C of the Internal Revenue Code are subject to double taxation. Two types of business entities are subject to subchapter C:
- C Corporations. Subchapter C is the default classification for all corporations. Corporations taxed under subchapter C are called C corporations.
- LLCs That Elect to Be Taxed as C Corporations. LLCs that elect to be taxed under subchapter C have the same double taxation problem as C corporations.
What Business Entities are Pass-Through Entities?
Four types of businesses are not taxed separately from their owners:
- Disregarded Entity. A disregarded entity is not treated as a separate entity for tax purposes. All earnings of a disregarded entity are reported on the owner’s tax return. If the owner is an individual, the business is treated as a sole proprietorship. Otherwise, the business is taxed under the classification that applies to the owner.
- Partnerships (Subchapter K). All income earned by a partnership is passed through to the partners. The partners pay the taxes associated with their allocated items of partnership income.
- S Corporations (Subchapter S). A small-business corporation that meets the eligibility requirements and elects to be taxed under subchapter S may avoid double taxation on its income. All income passes through to the shareholders, who are taxed individually for income earned by the corporation.
- LLCs Taxed as Sole Proprietorships, Partnerships, or S Corporations. LLCs that are taxed as sole proprietorships, partnerships, or S corporations are not taxed separately from their owners. All income is reported on the owners’ tax returns.
The ability to escape double taxation gives each of these business types a tax advantage over C corporations.