A Brief Overview of Business Types and Their Tax Treatment

A Brief Overview of Business Types and
Their Tax Treatment

Updated December 9, 2020
Congressional Research Service

A Brief Overview of Business Types and Their Tax Treatment

In the United States, how a business is taxed at the federal level is partly dependent on how it is
organized. The income of subchapter C corporations, also known as “regular” corporations, is
taxed once at the corporate level according to the corporate tax system, and then a second time at
the individual-shareholder level according to the individual tax rates when corporate dividend
payments are made or capital gains are recognized. This leads to the so-cal ed “double taxation”
of corporate income. Businesses that choose any other form of organization are, in general, not
subject to the corporate income tax. Instead, the income of these businesses passes through to
their owners and is taxed according to individual income tax rates. Examples of these alternative
“pass-through” forms of organization include sole proprietorships, partnerships, subchapter S
corporations, and limited liability companies.
This report summarizes the general tax treatment of corporate and pass-through businesses. The
intent is to introduce those who are unfamiliar with the current U.S. business tax environment to
the basics of corporate and pass-through taxation. Understanding how various businesses are
taxed provides a starting point from which one can evaluate current and future proposals to
change the taxation of corporations and pass-throughs. Additional y, since pass-through income is
typical y taxed only at individual income tax rates, this report is also a useful starting point for
understanding the effects on pass-through businesses from a change to individual income tax
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Introduction ................................................................................................................... 1
C Corporations ............................................................................................................... 4
Sole Proprietorships ........................................................................................................ 4
Partnerships ................................................................................................................... 5
S Corporations................................................................................................................ 6
Limited Liability Companies ............................................................................................ 7
199A Deduction.............................................................................................................. 8

Figure 1. Distribution of Business Tax Returns Filed in 2013 ................................................. 2
Figure 2. Net Business Income By Business Type, 1980-2015................................................ 3

Author Information ......................................................................................................... 8

Congressional Research Service

A Brief Overview of Business Types and Their Tax Treatment

In the United States, how a business is taxed at the federal level is partly dependent on how it is
organized. The income of subchapter C corporations, also known as “regular” corporations, is
taxed once at the corporate level according to the corporate tax system, and then a second time at
the individual-shareholder level according to the individual tax rates when corporate dividend
payments are made or capital gains are recognized. This leads to the so-cal ed “double taxation”
of corporate income (profits). Businesses that choose any other form of organization are, in
general, taxed only at the individual level. That is, the income of certain business types passes
through to their owners where it is taxed at individual income tax rates. Examples of these
alternative “pass-through” forms of organization include sole proprietorships, partnerships,
subchapter S corporations, and limited liability companies (LLCs).1
This report provides a general overview of the tax treatment of the major business types,
including sole proprietorships, partnerships, C corporations, subchapter S corporations, and
LLCs. Important nontax aspects of each business type are also presented and contrasted where
appropriate. This report does not, however, address every issue (tax or otherwise) related to the
major business types that could be of interest to Congress. Nor does this report discuss the tax
treatment of al the organizational forms available to businesses, such as trusts, regulated
investment companies (RICs), and real estate investment trusts (REITs).
Business taxation is a perennial interest of Congress for a number of reasons. The tax code can be
used to provide tax incentives to encourage particular business activities (e.g., investment or
hiring), assist certain types of businesses (e.g., smal or large businesses), and support the
businesses general y or stimulate the economy during periods of economic weakness (e.g., the
COVID-19 pandemic). How businesses are taxed also has important implications for how wel
capital and labor are al ocated throughout the economy. According to traditional economic
theories of taxation, there is no clear reason why otherwise identical businesses should be taxed
differently. According to the same theories, such differences in taxation result in an inefficient
al ocation of resources, which occurs at the expense of stronger economic performance and
standards of living.2

1 Sole proprietorships and single member limited liability corporations (LLCs) are technically disregarded entities. As
the first paragraph notes, economists usually group these business types in with the pass-through businesses. For a
disregarded entity there is no entity-level tax return, unless the LLC chooses to be taxed as a corporation. Unless the
LLC files as a corporation, all income is reported on the individual’s personal tax return, aggregated with other income,
and taxed according to individual tax rates.
2 In 1992, the Department of the Treasury drafted a 268-page report containing a comprehensive analysis of corporate
and individual tax integration. See Department of the T reasury, Integration of the Individual and Corporate Tax
System s: Taxing Business Incom e Once
, January 1992, https://www.treasury.gov/resource-center/tax-policy/
Documents/Report -Integration-1992.pdf. For a summary of the T reasury report, see R. Glenn Hubbard, “ Corporate Tax
Integration: A View from the T reasury Department,” Journal of Economic Perspectives, vol. 7, no. 1 (Winter 1993),
pp. 115-132.
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A Brief Overview of Business Types and Their Tax Treatment

Figure 1. Distribution of Business Tax Returns Filed in 2013

Source: CRS analysis of Internal Revenue Service, Statistics of Income, Integrated Business Data, Table 1
Note: Excludes REITs, RICs, and farm sole proprietorships.
It is perhaps useful to briefly quantify the business landscape across the various business forms
before proceeding. Figure 1 displays the distribution of business tax returns filed in tax year 2015
(the most recent data year). These data do not represent the number of business entities because,
for example, partnerships are comprised of at least two partners, each of whom must file a return
reporting their al ocation of the partnership’s income and tax items (discussed further in
“Partnerships” section).
The Internal Revenue Service (IRS) reports that there were approximately 35.0 mil ion corporate
and pass-through tax returns filed in 2015.3 The majority (72.0%) were from sole proprietorships.
The next most frequent returns filed were from S corporations (12.8%), followed by LLCs
(7.2%), and C corporations (4.6%). Partnerships (excluding LLCs) comprised the smal est share
of business returns filed (3.4%).

3 Internal Revenue Service, Statistics of Income, Integrated Business Data, T able 1, https://www.irs.gov/statistics/soi-
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A Brief Overview of Business Types and Their Tax Treatment

Figure 2. Net Business Income By Business Type, 1980-2015

Source: CRS analysis of Internal Revenue Service, Statistics of Income, Integrated Business Data, Table 1
Note: Excludes REITs, RICs, and farm sole proprietorships.
Figure 2 displays the share of net business income generated by the various business types
between 1980 and 2015. The most noticeable trend had been the decline in the share of income
generated by C corporations until the mid-2000s. Corporate income then spiked partly in response
to the 2004 corporate repatriation tax holiday, before fal ing during the Great Recession.4 Since
2008, corporate income trended upward as the economy recovered. At the same time, the shares
of income generated by S corporations and partnerships general y trended upward until the Great
Recession, after which earnings were flatter, perhaps reflecting a relatively slower economic
recovery than after past recessions. LLCs have also slowly increased their share of business
income since 1993, when LLCs first appeared as an option on the partnership tax form (this is
discussed in the “Limited Liability Companies” section). Sole proprietorships appear to have
possibly decreased in importance as a generator of business income, although it is difficult to
conclude whether this decrease is the result of a cyclical downturn followed by a relatively
modest recovery toward the end of the sample period, or a more permanent trend. In the end,
Figure 2 highlights the fact that pass-throughs are a significant source of economic activity,
generating over half (54%) of al business income in 2015.

4 For more information on the 2004 repatriation holiday, see CRS Report R40178, Tax Cuts on Repatriation Earnings
as Econom ic Stim ulus: An Economic Analysis
, by Donald J. Marples and Jane G. Gravelle.
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A Brief Overview of Business Types and Their Tax Treatment

C Corporations
A popular business structure is the corporate form, of which there are two types: C corporations,
which are discussed in this section, and S corporations, which are discussed later. C corporations,
also known as ordinary corporations, are named for Subchapter C of the Internal Revenue Code
(IRC), which details their tax treatment. Businesses incorporate under state law and the exact
requirements for incorporation may vary from state to state. Typical y, a business must first file
articles of incorporation at the state level in order to incorporate.5 A C corporation is considered
to be an entity that is separate from its owners (shareholders) for legal purposes. As a result,
shareholders are general y not legal y liable for the actions of the corporation.
The corporate form of organization al ows a business to take advantage of a number of benefits
not available with other forms of organization. Specifical y, a C corporation is not limited in the
number of shareholders it may have, the classes of stocks it may issue, the types of shareholders it
may have, or the citizenship of its shareholders. This is in contrast to the S corporations, which
are limited to one class of share they may offer, the types of shareholders, and the citizenship of
their shareholders. Shares of C corporation stock are also traded on wel -developed exchanges,
which al ows ownership interests to be transferred readily and at low transaction costs. As a
result, C corporations have the ability to raise capital global y from a variety of investors.
For tax purposes, the distinguishing feature of a C corporation is that it is a taxable entity. A
corporation’s business income is subject to a flat 21% tax at the corporate level. Any after-tax
income that is then distributed to shareholders in the form of dividends or recognized as capital
gains is taxed again at individual rates. This extra layer of taxation gives rise to what is known as
the “double taxation” of corporate profits.
Because a corporation itself is a taxable entity and directly responsible for paying taxes, taxable
income is computed at the corporate level. A corporation begins by aggregating al sources of
business income to arrive at total income. Income sources include sales revenue, investment
income, royalties, rents, and capital gains. To arrive at taxable income, the corporation then
deducts business expenses and other special deductions. Deductions include such things as
salaries and wages, bad debts, depreciation, advertising costs, and a portion of domestic
production activities, among others. Corporations are also al owed to deduct, subject to a limit,
interest paid to bond holders (but not dividend payments made to shareholders).6 As a result,
corporations may rely more on debt financing than they otherwise w ould.
Sole Proprietorships
A sole proprietorship is a business owned by a single individual and that is treated as identical
with its owner for tax and legal purposes. The sole proprietorship is the most common and basic
form of business organization. Unlike some other forms of business organization, a sole
proprietorship does not limit its owner’s liability. The business assets of the proprietorship as wel
as the personal assets of its owner may be used to settle any legal judgment against the business.

5 While a business may choose any state in which to incorporate, Delaware is by far the most popular. According to
Delaware’s Division of Corporations, over 60% of Fortune 500 companies chose Delaware as their state of
incorporation. See https://corplaw.delaware.gov/why-businesses-choose-delaware/.
6 T he interest deductions are complex, and much of this complexity stems from the international tax system governing
U.S. multinational corporations. For more information, see CRS Report R45186, Issues in International Corporate
Taxation: The 2017 Revision (P.L. 115 -97)
, by Jane G. Gravelle and Donald J. Marples.
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A Brief Overview of Business Types and Their Tax Treatment

In contrast, the limited liability protection provided by some other forms of business protects, to a
certain degree, the personal assets of the business owners from judgments against the firm.
The business income of a sole proprietorship is reported on a Schedule C attached to the owner’s
individual income tax return. The income is then taxed at the applicable individual income tax
rates. Taxable business income includes net profits distributed to the owner as wel as retained
earnings. In addition, a sole proprietor is responsible for paying the self-employment tax. The
self-employment tax rate is 15.3% and is composed of two parts: a Medicare tax (2.9%) and a
Social Security tax (12.4% only on the first $142,800 in 2021). Since 2013, an additional
Medicare tax of 0.9% applies to wage, compensation, and self-employment income exceeding
$250,000 for married joint filers, $125,000 for married separate filers, or $200,000 for al other
filers. The self-employment tax is analogous to the combined employer’s and employee’s share of
the Social Security and Medicare taxes, half of which is a payroll tax withheld by most
A partnership is a joint venture consisting of at least two partners, with each partner sharing
profits, losses, deductions, credits, and the like.7 A partner is an investor in such an entity and may
be an individual, a trust, a partnership, a corporation, another entity (such as a limited liability
company), or a broker that is holding the ownership interest of an unnamed partner. Partnerships
are established under the individual laws of each state, although their tax treatment at the federal
level is determined by the IRC.
The most common partnerships include general partnerships, limited liability partnerships, and
limited partnerships. A general partnership is one in which al partners are liable for the actions
and debts of the business. That is, the business assets of the partnership, as wel as the assets of
the partners, may be used to settle a legal judgment against the business. A limited liability
partnership (LLP) is a general partnership, usual y a professional firm, in which the partners are
mutual y liable for the partnership debts but are protected from the harmful actions of the other
partners. A limited partnership (LP) consists of at least one general partner and one or more
limited partners. The general partners oversee the management of the business and are liable for
the partnership’s debts. The liability of the other partners is limited to their capital contribution
and any additional amounts specified in the partnership agreement.
Partnerships themselves are not taxable; instead al tax items, such as income, losses, deductions,
and credits, pass through the partnership to the partners. The partnership reports each partner’s
al ocation to the IRS and to the partners according to the partnership agreement. The partners then
include their shares of income or loss on their own tax returns, even if there was no actual
distribution of income to the partners. As long as there are no corporate partners, business income
is taxed only at individual income tax rates. When a partnership does have a corporate partner, the
share of income al ocated to that partner wil be reported on the corporate tax return.
Although the partnership agreement determines the final al ocation of tax items to each partner,
the partnership must distinguish between ordinary income and separately stated items when
making the al ocation. Some items must be stated separately because the partners may face
limitations to the degree to which they may utilize certain tax items. For example, a capital los s

7 26 U.S.C. §7701(a)(2) defines a partnership as “ a syndicate, group, pool, joint vent ure, or other unincorporated
organization, through or by means of which any business, financial operation, or venture is carried on, and which is not,
within the meaning of this title, a trust or estate or a corporation .”
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A Brief Overview of Business Types and Their Tax Treatment

may affect partners differently if some are able to use it to offset a capital gain. Separately stated
items include capital gains and losses, dividends, tax-exempt interest, rents, royalties, deductions
attributable to portfolio income, charitable contributions, foreign taxes paid, and special
al ocation items determined by the partnership agreement. Ordinary income is the sum of income,
gains, losses, and deductions that need not be separately stated.8
In addition to being entitled to a share of the partnership’s profits or losses, partners may also be
given guaranteed payments for their contributions of capital or service. Such payments are fixed
and do not depend on the profitability of the firm. Fringe benefits such as health insurance are
also considered a guaranteed payment. The partnership deducts guaranteed payments as ordinary
business expenses, and the partners include them as ordinary income. To the extent that the
guaranteed payments are for personal services performed by a partner, the income is subject to
self-employment tax.
S Corporations
An S corporation is a “closely held” corporation that elects to be treated as a pass-through entity
for tax purposes. S corporations are named for Subchapter S of the IRC, which details their tax
treatment. By electing S corporation status, a business is able to combine many of the legal and
business advantages of a C corporation with the tax advantages of a partnership.
Several criteria must be met if a corporation wishes to elect S corporation status. The corporation
must be incorporated and organized in the United States. An S corporation can only issue one
class of stock and is limited to no more than 100 shareholders.9 The shareholders must be
individuals, estates, certain types of trusts, tax-exempt pension funds, or charitable organizations.
Al shareholders must be U.S. citizens or residents. Certain banks, insurance companies,
possession corporations (i.e., corporations predominately operating in a U.S. possession), and
other select business operations are ineligible to elect S corporate status.
An eligible corporation that seeks S corporation status must file a timely election with the IRS.
Each shareholder must consent in writing to the election. The shareholders agree to report and
pay tax on their shares of the corporation’s income. The election can be revoked with the consent
of shareholders holding more than 50% of the outstanding shares of stock. If an S corporation
election is revoked, the corporation cannot elect S status for five years without the consent of the
S corporations general y do not pay corporate-level income taxes. As with partnerships, operating
income and loss are computed at the corporate level and passed through to the shareholders, while
other items with special tax attributes are passed through separately. Separately stated items
include portfolio income, capital gains and losses, passive income and losses, charitable
contributions, foreign taxes paid, and the like. These tax items retain their character in the hands
of the shareholders, who report al ocations on their own returns, where the income is taxed for
individuals. If the shareholder is a pass-through entity, the income is passed through the
shareholder to the income beneficiaries of the pass-through entity.
An S corporation is not afforded the same flexibility as a partnership with respect to al ocations
among its owners. Because an S corporation is only permitted to issue one class of stock, al
al ocations must be proportionate to ownership. This includes the portion of al ocations that are

8 Kenneth E. Anderson, T homas R. P ope, and John L. Kramer, et al., Federal Taxation 2004: Corporations,
Partnerships, Estates, and Trusts
(Upper Saddle River, NG: Prentice Hall, 2004), pp. D-6.
9 Shareholders may, however, have different voting rights.
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A Brief Overview of Business Types and Their Tax Treatment

separately stated. S corporation shareholders are not subject to self-employment taxes on items
passed through the corporation. Like partners, shareholders who provide services to the
corporation general y are employees of the corporation. The corporation may deduct as expenses
wages, salaries, and some fringe benefits paid to these employees, but must also pay employment
taxes and withhold income and payroll taxes.
An area of contention between S corporations and the IRS is the structure of employee-
shareholder compensation. Compensation in the form of regular wages or salary is general y
subject to payroll taxes and unemployment taxes. Dividend distribution, however, avoids these
taxes. This provides an incentive for S corporations to pay, and for employee-shareholders to
receive, dividends in lieu of wages or salary. The IRS has attempted to address this issue by
reminding S corporations that they must pay “reasonable compensation” (subject to employment
taxes) to shareholder-employees in return for services, before dividend distributions.10
Compensation is considered reasonable when it matches what the market return would be to the
services provided by the employee. Failure to follow the IRS’s suggestion could result in the
reclassification of dividend compensation as wage or salary compensation for tax purposes.
An S corporation may be subject to the corporate income tax in certain instances. One such
instance is the recognition of a built-in-gain. A built-in-gain is recognized when an S corporation,
during the first five years of being an S corporation, disposes of an asset that had appreciated in
value while the business was organized as a C corporation.11 The tax rate on a built-in-gain is
equal to the corporate tax rate (currently 21%). To the extent that built-in-gain exceeds the
corporate tax owed on it, the built-in-gain passes through to shareholders who must report it as
taxable income. Taxes may also be imposed to recapture previous benefits from the use of
investment credits or the last-in-first-out inventory method by the C corporation. Final y, in
instances where more than 25% of a converted corporation’s gross receipts consist of “passive
investment income,” a corporate income tax may be imposed. The tax is equal to the corporate
tax rate and is applied to net income attributable to the excess over 25% of gross receipts. Passive
investment income includes such things as dividends, interest, rents, royalties, and capital gains .
Limited Liability Companies
A limited liability company (LLC) can combine the favorable tax treatment of a partnership with
the limited liability features of a corporation.12 An LLC, like a partnership, is provided the
flexibility to al ocate income, losses, deductions, and credits in an amount different than
members’ ownership interests.13 The income of a C corporation, on the other hand, is general y
distributed to its shareholders in a manner predetermined by rights inherent in each class of stock
and the amount of each class of stock a shareholder owns. An S corporation is similarly
constrained in the al ocation of income, losses, and deductions to its shareholders.
LLCs, like corporations, are entities that are separate from their members or owners. As a result,
members may not be responsible for the debts of the company.14 There is no limit to the number

10 Internal Revenue Service, Paying Reasonable Compensation to the S Corporation Shareholder-Employee,
Stakeholder Headliners, vol. 32, Washington, DC, December 10, 2002.
11 T he Protecting Americans from T ax Hikes Act of 2015 (Division Q of P.L. 114-113) reduced the 10-year realization
period to 5 years.
12 John E. Moye, The Law of Business Organizations, 6th ed. (Clifton Park, NY: T homson Delmar Learning, 2004),
p. 121.
13 T he owners of an LLC are referred to as “members.”
14 If, however, the lender requires members to sign as individual members of the LLC, they could be responsible for the
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A Brief Overview of Business Types and Their Tax Treatment

of members an LLC may have, unlike with an S corporation. In addition, LLCs are permitted to
have multiple classes of ownership interests.
LLCs are relatively recent creations. Wyoming was the first state to al ow LLCs in 1977,
followed by Florida in 1982.15 By the mid-1990s, LLC laws had been enacted in al states.16
For many years, the IRS had held that any organization would be taxed as a corporation if it had
the major characteristics of a corporation. LLCs were designed to lack enough corporate
characteristics to avoid such a classification. In most cases, this was accomplished in one of three
ways: having the company nominal y cease to exist upon the withdrawal of a member; placing
restrictions on the transferability of ownership interests; or designating al members as nominal
In 1997, the IRS issued final regulations that in effect al ow companies to elect how they wil be
taxed by simply checking a box on a form.17 These regulations are typical y referred to as “check-
the-box” regulations. A single-member LLC can elect to be taxed as either a C corporation or a
sole proprietorship. A multimember LLC can elect to be taxed as either a partnership or a C
corporation. These rules apply to any entity that is not otherwise required to file as a corporation
or a trust. In general, a business may not change its classification during the 60 months following
a check-the-box election.
199A Deduction
Between 2018 and 2025, al pass-through businesses are potential y eligible for a deduction equal
to 20% of qualified business income (QBI). The deduction, commonly referred to as the 199A
deduction after the tax code section it is located under, was enacted as part of P.L. 115-97, also
known as the Tax Cuts and Jobs Act (TCJA). The deduction reduces the amount of business
income subject to tax, thus lowering the effective tax on pass-through income. Part of the
rationale for enacting the tax was to create parity between the tax treatment of corporate and pass-
through businesses. Although conceptual y the deduction appears straightforward, the
computations and limits used in determining the deduction are rather complex. For more
information on the mechanics of the deduction, see CRS Report R46402, The Section 199A
Deduction: How It Works and Illustrative Examples, by Gary Guenther.

Author Information

Mark P. Keightley

Specialist in Economics

15 Larry E. Ribstein, “T he Emergence Of T he Limited Liability Company,” The Business Lawyer, November 1995,
p. 1.
16 Paul A. McDaniel, Martin J. McMahon, and Daniel L. Simmons, Federal Income Taxation of Business
, 3rd ed. (New York: Foundation Press, 1999), p. 8.
17 T reas. Reg. §301.7701-3.
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A Brief Overview of Business Types and Their Tax Treatment

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