Flow through entities vs. C-Corp Taxation
Taxation is one of the most important aspects of business that entrepreneurs should understand before taxes are due. There are two major types of taxation for business entities, each of which will be discussed in this article. Flow-through taxation applies to limited liability companies (LLC’s), and S- Corporations. C corporations, on the other hand, are subject to “double-taxation”. We hope the following explanations help clarify the important difference between these two types of taxation so as to reduce the complexity for you.
Flow through taxation means that there is no entity-level tax. Instead, profits and losses “flow through” to the owners. Therefore, when the business pays a dividend to its owners, they have to pay taxes on their distribution, but the business does not pay taxes on its profits. This essentially reduces the overall tax burden, and allows owners to keep more of their money than does the double-taxation model. If an LLC made $1,000 in profits it would have $1,000 dollars that it could distribute to the shareholders. If there were 4 shareholders, each with an equal percentage holding in the firm, they would each receive $250 and would pay taxes on their dividend at their individual tax rate.
Double-taxation means that profits are taxed two times – the entity pays taxes on profits, and stockholders pay tax again when they receive distributions. Therefore, under a double-taxation scheme a shareholderwould pay taxes on his dividend even after the C-corporation has already paid taxes on its profits. This taxation scheme reduces the amount that a shareholder keeps when compared to pass-through taxation. To use the same numbers as were used in the example regarding flow-through taxation above, if a C-corporation made $1000 in profits and was subject to a 20% tax at the corporate level, it would have $800 to pay out to shareholders after it paid taxes on that $1,000 in profits. However, under double-taxation the shareholders would also also pay taxes on their distributions. If there were 4 shareholders with an equal percentage of shares, they would each receive a dividend of $200. If they were each taxed at a 10% level, they would each net $180, instead of the $225 that they would net under the pass-through system.
It is important to remember that the tax schemes are simply IRS designations. In other words, LLCs can be taxed as partnerships or S-Corps (or even the same as a C-corporation, although that is relatively rare). Corporations can be taxed as S-Corporation or C-Corporations. It is also important to remember that S-Corporations carry with them certain restrictions, and that partnership accounting is…very complicated. So, while a C-Corp suffers from double taxation, as discussed above, the accounting side can be much simpler – and the shareholders in a C-Corp only pay taxes on the dividends they actually receive. Because the C-Corporation pays its own income taxes, it is able to hold corporate profits (to some extent — please consult your CPA or tax advisor!!) and shield the stockholders from tax liability. On the other hand, a pass-through tax model (partnership or S-Corp) requires equity owners to pay taxes on the amount of profit allocated to them based on their ownership percentage, regardless of whether the company actually pays out distributions or not. This is why a well-draft operating agreement will require the Managers to make “tax distributions” to the members each year in an amount that will cover the tax obligations of the member in the highest tax bracket.
Please note – the lawyers at Fourscore Business Law are experienced in business matters of many kinds, which give us the opportunity to be involved in tax discussions on a regular basis. However, we are not CPAs or “tax” lawyers. We have many great contacts and refer our clients to them when needed. Please do not take the summary set forth in this article as tax or business planning advice!