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Choosing the Right Legal Structure for Income Tax

While deciding which type of legal business structure is best for securing capital and managing their business, owners should also consider the income tax factor. They should know the key differences between the two kinds of business entities from the income tax point of view:

  • Taxable-entity, C corporations: These corporations are subject to income tax on their annual taxable income. Plus, their stockholders pay a second income tax on cash dividends that the business distributes to them from profit, making C corporations and their owners subject to double taxation. The owners (stockholders) of a C corporation include in their individual income tax returns the cash distributions from the after-tax profit paid to them by the business.

  • Pass-through entities — partnerships, S corporations, and LLCs: These entities do not pay income tax on their annual taxable income; instead, they pass through their taxable income to their owners, who pick up their shares of the taxable income on their individual tax returns.

    Pass-through entities still have to file tax returns with the IRS, even though they don't pay income tax on their taxable income. In their tax returns, they inform the IRS how much taxable income is allocated to each owner, and they send each owner a copy of this information to include with his or her individual income tax return.

Most LLCs opt to be treated as pass-through entities for income tax purposes. But an LCC can choose instead to be taxed as a C corporation and pay income tax on its taxable income for the year, with its individual shareholders paying a second tax on cash distributions of profit from the LLC.

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