Taxation of Corporations vs Pass-Through Entities
by Paul Share
In consideration of what type entity to use for your startup, taxation is a major consideration. In our previous post, we discussed, in general terms, how taxation works for “pass-through” entities like sole proprietorships and partnerships. In this post we discuss how taxation works for corporations, as contrasted with pass-through entities.
Corporations are deemed to be separate entities, under U.S. law—especially tax law. This means a corporation files an income tax return reporting its income and losses, and pays taxes on this income. Unlike pass-through entities, the income and losses of a corporation are not attributed to its equity owners.
One aspect of a corporation being deemed a separate entity is, when a corporation distributes part of its income to its shareholders (a “dividend”), the distribution is treated as income to the shareholders. This is opposed to pass-through entities like partnerships, whose property (including income) is considered the jointly owned property of the partners. Thus, for pass-through entities, a distribution to its partners of income or most other assets is not considered to be a taxable event.
This gives rise to so-called “double-taxation” on the income of corporations. A corporation pays federal and local taxes on its income at the corporate tax rate. Then, if the corporation wishes to distribute this income to its shareholders as a dividend, the shareholders pay income tax on the dividend. So the distributed amount of the corporation’s income is taxed twice: once at the corporate level and once when received by the corporation’s shareholders as a dividend.
This double taxation can be a disadvantage if a corporation is likely to have income that it does not need to reinvest in the business, and which it wishes to distribute to its shareholders. In recent years, the U.S. federal tax rate on corporate income has been reduced from 35% to 21%, reducing the burden of overall taxation of corporations and thus making double taxation more bearable.
On the other hand, if a startup is likely to have a lot of income it will need or wish to keep in the company to fund its growth, being a pass-through entity like a partnership can be a disadvantage. As previously noted, each equity owner of pass-through entities has to include their pro-rata portion of the entities’ income as part of their income, then pay tax on this included income at their personal tax rate.
So if a pass-through entity retains, and does not distribute to its owners, any portion of its income, the owners will have to pay tax on this retained income—even though they never received it. Paying taxes on money you receive is bad enough. Surely paying taxes on money you don’t receive is much worse!
One work-around often employed for this problem is for pass-through entities to require a distribution to members every year large enough to cover that tax liability of owners in portion to the entity’s income. But there are problems with this solution.
First, the tax liability of an entity’s owners is calculated at each owner’s tax rate. And that rate varies, depending on each owner’s total taxable income and the state and locality where the owner lives. To deal with this, pass-through entities sometimes distribute an amount based on the highest tax rate of any of its owners.
Second, the personal tax rates for most investors is higher than the 21% rate for corporations. So, when a pass-through entity distributes enough money to its owners to cover their tax liability for its income, they have to distribute more than the amount of tax they would have paid on that income if it where a corporation and paying taxes at the 21% corporate rate. This leaves less money to use to grow the business.
The fact that a corporation is deemed to be a separate entity for tax purpose also means that the equity holders of a corporation are not entitled to take corporate losses as deductions from their personal taxes. This can be a disadvantage for startups likely to operate at a loss in their early years if investors are unable to use deductions to offset income from other sources.
Paul Share began legal practice in 1973, specializing in corporate and securities law. He also has extensive experience in loan agreements, the formation, acquisition and sale of businesses, and the negotiating and drafting of a wide variety of contracts, including employment agreements, shareholder agreements, leasing agreements, and software development and licensing agreements and the representations of start-ups and high-tech companies.