Entrepreneurship and Small Business (ESB) Certification Practice Exam

Which type of business structure provides a lower tax rate and prevents the company from being double-taxed?

1. S corporation

2. Partnership

3. LLC (limited liability company)

4. Corporation

The correct answer is: S corporation

An S corporation is designed to avoid the issue of double taxation, which is a key advantage of this business structure. Unlike a traditional corporation, where the company's profits are taxed at the corporate level and again at the individual level when distributed as dividends, an S corporation allows income, losses, deductions, and credits to pass through directly to the shareholders. This means that the S corporation itself typically does not pay federal income tax, and instead, the income is reported on the shareholders' personal tax returns. As a result, the tax rate on the income can be lower, since it avoids the double taxation that occurs with regular corporations. The other business structures, such as partnerships and LLCs, also provide pass-through taxation, which means profits are taxed on the individual partners' or members' tax returns rather than at the entity level. However, they may not offer the same formal structure and benefits as an S corporation, particularly in terms of raising funds and limited liability for shareholders. Regular corporations, on the other hand, are subject to both corporate tax and personal tax on dividends, which is what leads to the double taxation issue that an S corporation effectively mitigates.