Forming a business is usually a simple process that can be completed in a few minutes through your state’s Secretary of State website.
Deciding how to structure your business may not be so straightforward. Taxation rules and tax consequences are very different for certain business entities, especially corporations. In this article, we’ll discuss how corporations are taxed compared to other business common entities, which will paint a clear picture of which sources of income are subject to double taxation.
Common Business Entities
Most businesses are formed as one of the following entities:
- Limited partnership (LP)
- Limited liability partnership (LLP) or company (LLC)
- General Partnership
- Sole Proprietorship
Partnerships and sole proprietorships don’t require you to complete a formal filing with your state’s Secretary of State.
Now let’s take a closer look at how corporations are taxed.
Taxation on Corporations
Corporations have a unique tax structure compared to other business entities.
Sole proprietorships, LLCs, partnerships, and S-corps are considered pass-through entities – profits generated from business operations flow through to the registered owners or business members. Profits are taxed at the individual level according to the taxpayer’s filing status and gross income, which can be as high as 37 percent for single taxpayers with more than $578,125 of income or married couples with more than $693,750 in 2023.1
Corporations, meanwhile, pay a flat federal tax rate of 21 percent regardless of the amount of profit the corporation nets. Additionally, 44 states and the District of Columbia impose state-level corporate income taxes. New Jersey had the highest combined tax rate in 2022 at 30.1 percent, while Ohio, Nevada, Wyoming, Washington, Texas, and South Dakota levy no additional state corporation tax (though Texas, Washington, Nevada, and Ohio impose gross receipts taxes).2
The flat corporation tax rate is lower than the top five marginal tax rates for individuals or married couples who file joint returns (22, 24, 32, 35, and 37 percent). However, much of the benefit of a lower corporate tax rate is diluted by double taxation that corporations must pay in certain situations.
Corporate Income That’s Subject to Double Taxation
Double taxation is exactly what it sounds like – corporations are required to pay income taxes twice, once on their annual profits and again on any dividends or capital gains that are paid out to a corporation’s shareholders.
C-corps are the only business entity that faces double taxation. The first tax is always the flat federal rate of 21 percent (followed by state-level corporate taxes, where applicable). Taxes on capital gains or ordinary dividend distributions, meanwhile, are levied at the taxpayers’ nominal tax rate. Qualified dividends, which must meet certain requirements, are taxed at capital gains tax rates of 0, 15, or 20 percent.
Putting it all Together
Corporate income is taxed twice. The first tax is levied at the entity or business level, and income is taxed once again at the shareholder or personal level if the corporation distributes income to shareholders in the form of stock dividends.
You’ll pay taxes on ordinary dividends at your nominal tax rate, but qualified dividends are taxed at more favorable long-term capital gains rates. A certified tax professional can provide additional insight into corporate taxation and how dividend income affects your tax return.
1 Key Elements of the U.S. Tax System, Tax Policy Center, https://www.taxpolicycenter.org/briefing-book/what-are-pass-through-businesses
2 Combined Federal and State Corporate Income Tax Rates in 2022, Tax Policy Center, https://taxfoundation.org/combined-federal-state-corporate-tax-rates-2022/
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.