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.
Most businesses are formed as one of the following entities:
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.
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.
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.
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/