C Corps vs. LLCs: Why “Double Taxation” Is A Myth For Startups

In the US businesses are taxed on the money they make. Revenue can be taxed through sales taxes, and profits are taxed as corporate income. When choosing a corporate structure for your new company and deciding between LLC vs. corporation, there are a myriad of factors to consider, but taxes play an important role in deciding on the type of business entity you use.

Tax stuff can sometimes be confusing to startup founders. There are tons of myths and folk wisdom about taxation and how to reduce its accounting and financial burden on companies. Both limited liability companies (LLCs) and C Corps offer limited liability protection to the owners and directors by creating a separate entity for doing business, but how a companies pay taxes depends on the choice of business structure.

You might’ve heard that C Corporations are taxed more than LLCs, that income is taxed twice. Spoiler alert: that last part is technically true, but double taxation is not an issue for startups. It’s merely a myth!

How did this myth come about? For small business owners who run profitable businesses like restaurants, using an LLC is a way of avoiding double taxation. But, this rarely ever applies to startups who can take advantage of other tax benefits that only apply to C Corps and not LLCs such as QSBS.

There are many reasons why startup founders choose to register their company as a corporation instead of an LLC, namely that it is easier to issue stock options to employees and raise capital from investors by using a C Corp.

In this article, we will cover how the choice of business entity for your new startup can have consequences for both your company taxes and personal taxes, including:

• The basics of corporate income taxes and how the choice of business entity affects taxation
• The main differences between how corporate income is taxed for LLCs vs C Corporations
• Why incorporating as a C Corporation makes more sense for tech startups, from a tax perspective

In the U.S. “corporate income” is defined as profit: the money left over after a company makes more money than it spends over a period of time.

All corporations registered in the US must file annual tax returns with the IRS. If you file your articles of incorporation to register a new corporation in a 2023, you will need to file a tax return for 2023, even if your company incorporates on December 31, 2023.

Accordingly, corporate income tax is collected on that profit, and in 2022 the U.S. federal corporate tax rate is around 21%.

Many states levy separate corporate income taxes, which can range from as little as 0% to as much as 11.5%, depending on the state. Additionally, some municipalities have their own corporate income taxes, but for the sake of this guide, we are going to focus on corporate income taxes at the federal level.

Keep in mind that a stock corporation can choose to be taxed as a pass-through entity like an LLC, which is known as an S Corporation. The distinction in type of corporation—S Corp and C Corp—has to do with the corporate tax status of the entity. We won’t cover all the details why in this article, but it is extremely rare for startups to be structured as S Corp, as this entity type is not favored by investors.

From a tax perspective, income (profits) generated by LLCs and C Corporations is treated very differently. In short, there is a separate corporate income tax paid by C Corporations, but there’s no separate income tax paid by LLCs. The specifics are a little more tricky, so let’s dive into it.

Let’s start with LLCs.

Limited liability companies or LLCs are treated as pass-through entities, which means the profits (and losses) they generate are transferred to the members of the LLC and get reported as individual income on Form 1040. The tax treatment of LLCs is similar to a sole proprietorship but with a liability shield for business owners that allows them to shield personal assets and avoid personal liability in most lawsuits relating to the company’s business activities.

A single-member limited liability company (LLC) is treated as a disregarded entity, which means that its profits and losses are directly attributed to its owner and there are no additional filing requirements. Functionally, from a tax perspective this is the same as being a sole proprietor. However, multi-member LLCs issue IRS Form K-1s on an annual basis, and the profits (or losses) reported by the LLC are split according to each member’s proportional share of the company.

To reiterate, regardless of the number of members in an LLC, business income and losses are taxed as individual income, which on a marginal basis can be taxed at a rate of up to 37% in 2022. So, if an LLC has 2 members with equal stakes in the business and generates $1.5M in profit, each member will report $750,000 in income to the IRS. At current tax brackets, each member will pay roughly $237,000 in taxes, at an effective tax rate of 31.6%, leaving each with around $513,000 to take home (assuming no other income or deductions).

Keep in mind that owners of a single-member LLC or multi-member LLC will still be responsible for paying self-employment taxes, since Social Security and Medicare taxes are not automatically deducted by the LLC on pass-through income.

Many cash-flow positive businesses that provide services or sell goods are registered as limited liability companies. This structure makes sense for small business owners of small businesses (like restaurants, ad agencies, hardware stores, and so on), but is not usually the best choice for startup entrepreneurs.

Now let’s look at C Corporations.

Most startups register as Delaware C Corporations, instead as forming an LLC, because this business structure makes it easier to issue stock and is the preferred entity type for venture capital funds and angel investors. Corporations are nominally more complex than LLCs and must have a board of directors, adopt bylaws, hold regular shareholder meetings and file an annual report with state officials.

From a legal and tax standpoint, C Corps are treated as their own distinct entities. In this regard, that old saw of “corporations are people, my friend” holds true, at least from an income tax perspective.

As we said earlier, corporate income is taxed at an income tax rate of around 21%. Using numbers from the scenario above, a corporation which generated $1.5M in profit would have to pay $315,000 in federal corporate income taxes, leaving $1,185,000 in earnings to either save or distribute to shareholders. If those earnings are distributed to shareholders, such as via a dividend payment, those distributions are usually taxed as ordinary income to shareholders. (Note: Under certain conditions, dividends from publicly traded companies can be taxed as capital gains.)

That’s what folks mean when they say there is “double taxation” of corporate income. The company pays tax on profits at the corporate level, then you pay personal income tax (in addition to Social Security and Medicare taxes) on any salary you receive from the company when filing your personal tax returns with the IRS.

However, for startups (and even a lot of public companies), double taxation is not really a factor for executives, investors, employees, and other stakeholders in a corporation. In other words, the myriad benefits of starting up as a C Corporation far outweigh the risk of additional tax burden, since double taxation is almost always a non-issue. Let’s see why.

While it’s true that corporate income can be taxed twice (first as corporate income tax, and then as individual income tax), there are many reasons why the vast majority of startups won’t have to worry about it.

Here are a few of those reasons:

1. Early-stage startups, almost by design, are not profitable. Most startups don’t make any money in their first few years of existence. Building a product costs money and can take a long time, and it’s hard to generate revenues (let alone profits) without a product in the market. And, heck, some companies go public without ever turning a profit, including recent examples like Airbnb and Palantir Technologies.
2. When startups do generate revenue, it’s reinvested in growth. Even when a startup is generating revenue, all of that money is getting reinvested into the business to accelerate its growth. This happens with some big public companies too; famously, Amazon operated at break-even or unprofitably for years as it reinvested its (sizable) revenues into R&D and business expansion.
3. Startups rarely issue dividends. Since startup companies rarely operate profitably, and that any money taken off the table through dividend payments to shareholders is money that can’t be invested in growing the business (and, thus, the valuation of the company), it doesn’t make sense for startups to issue dividends.

The job of a startup founder and her leadership team is to grow the value of her company’s equity as quickly as possible. That’s how startup shareholders—ranging from founders and employees to investors and advisors—get their big payday.

The secondary advantage to the strategy of rapidly growing the company’s valuation is that, if and when a startup goes public or gets acquired, the proceeds from that liquidity event are most likely going to be taxed as capital gains, and may be eligible for QSBS exemptions—the latter of which could save a founder potentially tens of millions of dollars in taxes. In other words, despite the theoretical possibility of double taxation, the reality is that there are far more tax advantages to corporations and their shareholders when pursuing a high-growth startup strategy.

• While both offer limited liability protection to owners, LLCs and C Corporations are treated very differently for tax purposes.
• LLCs are pass-through entities, which means that their income isn’t taxed directly; rather, members of the LLC are responsible for paying their share of taxes on profits through individual income taxes. Your LLC does not pay a separate corporate income tax.
• As standalone legal entities, corporations are responsible for paying a separate corporate income tax on profits, and any profits distributed through dividends to shareholders are again taxed as individual income (but sometimes as capital gains).
• Double taxation may be real but it’s a non-issue for startups, since high-growth companies don’t typically generate taxable profits for several years (if ever).
• There are many other tax benefits that apply to stockholders (founders, early employees and investors) for a new company formed as a C Corporation—which far outweigh the unlikely possibility of double taxation. Only companies registered as C Corps can make use of the QSBS exemption and preserving this tax status is important to both founders and early stage investors.