Double Taxation vs Pass-Through Entities

Find out which businesses are subject to double taxation on their income and which escape double taxation as pass-through entities.

Attorney Takeaways:

  • The IRS classifies businesses into two broad categories: those that are taxed twice on income and those that are not.
  • Disregarded entities, S corporations, and partnerships are pass-through entities that escape double taxation.
  • C corporations are not pass-through entities, so their income is taxed twice.

What is Double Taxation?

The term double taxation refers to the two layers of tax imposed by subchapter C of the Internal Revenue Code.1 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 the business distributes profits 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 to distribute 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?

A pass-through entity is a form of business that is not treated as a separate taxpayer under subchapter C. A pass-through entity does not pay an entity-level tax on its income. Instead, all business income passes through to the owners, who report it on their personal income tax return (and pay personal income taxes at their effective marginal rate). Because the business does not pay an entity-level tax (because the business income is taxed to the owners and not to the business entity), 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?

The Internal Revenue Code taxes LLCs 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 passes through to the owners when earned and only taxed once, on the owners’ tax returns. The Internal Revenue Code does not tax the LLC separately from its owners.

LLCs can change their default classification by electing to be taxed under Internal Revenue Code subchapter C or subchapter S. 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 loses pass-through treatment and is subject to double taxation.

See How to Choose a Tax Classification for an LLC for a discussion of how to choose the right tax classifications for an LLC.

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:

  1. C corporations. Subchapter C is the default classification for all corporations. Corporations taxed under subchapter C are called C corporations.
  2. 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.
Attorney Practice Note: Although subchapter C is the default tax classification for corporations, corporations that meet strict eligibility requirements may file an election to be taxed under Internal Revenue Code Subchapter S. Corporations that meet these requirements are called S corporations.

What Business Entities Are Pass-Through Entities?

There are four types of pass-through business entities:

  • 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. The partnership may be either a general or a limited partnership under state law.
  • 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.

With the exception of general partnerships (which provide no liability protection to the owners), each of these entities protects the owner from liability without incurring business taxes. The ability to escape double taxation gives pass-through entities a tax advantage over C corporations.

  1. I.R.C. Subchapter C.