Double Taxation

The profits of corporations are taxed twice -- once at the entity level (at the applicable state and federal corporate income tax rate), and again at the individual level when profits are distributed to individual owners as dividends (at the applicable individual income tax rate). Avoiding double taxation is one of the commonly noted advantages of operating as a sole proprietorship, partnership, or LLC. Nonprofit organizations that qualify for 501(c)(3) status are exempt from federal (and usually state) income tax at the entity level, so in a sense they avoid double taxation as well.

As noted, avoiding double taxation generally is considered advantageous, but it may not always prove beneficial, depending on your particular circumstances. Owners of businesses whose income "passes through" to them for tax purposes must pay income tax on their share of the net profits of the business, regardless of the amount of money they actually take out of the business each year. Thus, even if all profits are reinvested into the business, the owners of these businesses must pay taxes on their share of the profits. Shareholders of a corporation, on the other hand, pay income tax only when those profits are actually distributed to them as dividends. In addition, paying reasonable salaries to shareholders who participate in the operation of the business can ameliorate the burden of income tax at the entity level to a certain extent. Additionally, there may be situations where you as an individual pay income tax at a rate that is higher than the corporate tax rate.

Note: Tax questions are complex, and the details of such questions are beyond the scope of this guide. Consult a tax accountant and an attorney (if necessary) before choosing a business entity based on tax issues.


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