How are corporations taxed?
Takeaway: A C-Corporation is subject to "double taxation"—the corporation pays tax on its profits, and its stockholders pay a second layer of tax on any dividends they receive or on the capital gains from selling their stock.
One of the most fundamental characteristics of a C-Corporation, and the primary reason that other entity types like LLCs and S-Corps exist, is its unique tax structure. Unlike a partnership or an S-Corp where profits "pass through" directly to the owners to be taxed on their personal returns, a C-Corporation is a completely separate taxpayer in the eyes of the IRS. This creates a phenomenon known as "double taxation."
For a venture-backed startup, this is not a flaw; it is a necessary feature of the corporate structure required to raise institutional capital. Understanding how this tax treatment works is essential for sound financial planning.
Layer 1: The Corporate Income Tax
A C-Corporation is taxed on its net profits at the corporate level.
How it Works: The company generates revenue and incurs business expenses. At the end of the year, it calculates its net income (profits) and pays federal and state corporate income tax on that amount.
The Benefit of Reinvestment: In the early years, your startup is unlikely to have any profits. You will be reinvesting all of your capital and operating at a loss. These losses can often be carried forward to offset profits in future years. Because the profits are retained and taxed within the corporation, it allows the company to reinvest its earnings into growth without the founders having to pay personal taxes on that retained value.
Layer 2: The Tax on Stockholders
The "double taxation" occurs when the corporation's after-tax profits are distributed to its stockholders. This second layer of tax can happen in two primary ways:
Tax on Dividends: If the corporation decides to distribute its profits to its stockholders in the form of a dividend, that dividend payment is considered taxable income to the stockholders who receive it. They will have to pay tax on that dividend at their individual dividend tax rate. So, the profit was taxed once at the corporate level, and then again when it was distributed to the owners. (Note: For early-stage startups, paying dividends is extremely rare, as all profits are reinvested in growth).
Tax on Capital Gains: This is the more relevant scenario for a startup. When you, as a founder or employee, sell your stock for a profit during an exit (an acquisition or after an IPO), that profit is a capital gain. You will pay a personal capital gains tax on the difference between your sale price and your original purchase price (your "cost basis"). This is the second layer of taxation. The value created within the corporation is ultimately taxed again when it is realized by the individual stockholders.
This double taxation structure is the fundamental trade-off for the limited liability and investment-friendly nature of the C-Corporation. While it may seem inefficient, it is the universal and accepted structure for building a high-growth, venture-backed company, and the powerful benefits of QSBS are specifically designed to mitigate this double tax burden for stockholders in qualifying small businesses.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.