Most large U.S. companies are structured as corporations, which are separate legal entities from their owners [source: McGraw-Hill Higher Education]. They are also separate tax entities: To the IRS, the corporation is a person to be taxed like any other person. In terms of tax filing, this means a lot of complicated paperwork, and owners often shell out cash to have tax pros deal with it. This can be a significant expense.
Even more significant, in terms of business income tax, it means profits are often taxed twice.
Since the business is a tax entity unto itself, it pays its own income tax on any profits it earns. Then, when those profits are distributed to shareholders as dividends, those shareholders pay income tax on it through their individual tax returns. This double taxation is one of the main tax drawbacks to the corporate business structure.
On the upside, a corporation doesn't have to distribute every last penny. It's allowed to keep some of its profits in the company, typically (or ostensibly) to cover post-filing expenses or to put toward future growth [source: Laurence]. This can be a tax advantage: While that undistributed money is still taxed a second time, it's taxed at the corporate income-tax rate, which is often lower than the owners' personal rates [source: Laurence].
To avoid double taxation on profits, and to reduce the (potentially expensive) complexities of tax filing, many smaller businesses choose to organize as one of the pass-through tax entities. Sole proprietorships, partnerships and S corporations are all pass-through entities; they and their owners are the same tax entity in the eyes of the IRS, so income tax is only levied once [source: SBA]. All profits "pass through" the business to its owners, who pay income tax on that money when they file their personal tax returns.
Pass-through entities can potentially save a lot when it comes to income tax. It's single versus double taxation. Easy decision, right?
Not always. Pass-through entities can get slammed when it comes to Medicare and Social Security.