Published on: Feb 15, 2024 by Molly Taylor - CPA, MT
Updated on: November 11, 2024
The entity structure of a business plays a significant role in determining its tax treatment and can be a powerful tool in minimizing tax liability.
Each type of business entity has its own tax implications, and choosing the right structure depends on various factors, including the nature of the business, number of owners, revenue size, and growth plans.
Here are the primary business structures and how they can impact tax liability.
A sole proprietorship is one of the simplest and most common forms of business ownership, where the business is owned and run by one individual with no distinction between the business and the owner. Here are the key tax implications associated with a sole proprietorship:
The income earned by a sole proprietorship is treated as the owner's personal income. The business itself does not pay income tax; instead, the owner reports business income and expenses on their personal tax return. The owner files IRS Form 1040 for their personal taxes and includes Schedule C, which details the business's profits and losses.
Sole proprietors must pay self-employment tax, which covers Social Security and Medicare contributions. This is calculated on the net earnings of the business. Self-employment tax is reported on Schedule SE, which is filed along with the personal tax return.
Since taxes aren't withheld from their earnings, sole proprietors typically need to make estimated tax payments on a quarterly basis, if they expect to owe $1,000 or more when their return is filed.
Home Office Deduction: If a sole proprietor works from a home office, they may be eligible to deduct expenses related to the business use of their home.
Health Insurance Deduction: Sole proprietors can often deduct premiums paid for medical, dental, and long-term care insurance for themselves and their families.
Retirement Contributions: Contributions to a self-employed retirement plan, like a SEP IRA or a Solo 401(k), can reduce taxable income.
In a partnership, the tax liabilities are structured around the concept of "pass-through" taxation. This means the partnership itself does not pay income taxes directly. Instead, the profits and losses of the business are passed through to the partners, who then report this income on their personal tax returns. Here's a breakdown of the key aspects of tax liabilities for a partnership:
The partnership itself does not pay income taxes. Instead, the income, deductions, losses, and credits from the partnership pass-through and are reported on the partners’ personal income tax returns. To help with reporting, each partner will receive a Schedule K-1 from the partnership which reports their share of the partnership's income or loss.
General Partners share in the management of the business and are considered self-employed. In addition to income taxes, they are responsible for paying self-employment taxes (Social Security and Medicare taxes) on their share of the partnership's income. These taxes are not withheld from distributions and must be paid by the General Partners directly, usually through estimated tax payments.
Limited Partners are generally not subject to self-employment taxes on their share of the income from the partnership.
Distributions to partners are typically not taxable as long as they do not exceed the partner's basis in the partnership. A partner's basis is initially the amount of money or value of property contributed to the partnership. It increases with the partner's share of income and decreases with the share of losses and distributions.
Partnerships have flexibility in how they allocate income and losses among partners, as the allocation of income, losses, deductions, and credits is governed by the partnership agreement. It's important that a partnership’s allocations have substantial economic effect or otherwise reflect the partners’ interest in the partnership.
Since taxes are not withheld from their earnings, partners may need to make quarterly estimated tax payments to cover their tax liability.
The partnership must file an annual information return (Form 1065) with the IRS. This form reports the partnership's income, deductions, gains, losses, etc.
Each partner receives a Schedule K-1 form from the partnership, detailing their share of the partnership's income, deductions, credits, etc., which they use to complete their personal tax return.
Partnerships generally must use a calendar year as their fiscal year unless they can establish a business purpose for a different fiscal year.
A C corporation is a legal structure for a corporation in which the entity itself is taxed. This structure has distinct tax liabilities and obligations, which are important for business owners to understand:
Unlike pass-through entities (like Partnerships and S corporations), C corporations are subject to corporate income tax at the entity level. This means the corporation itself pays taxes on its profits.
The federal corporate income tax rate in the United States is currently 21%.
In addition to federal taxes, C corporations may be subject to state corporate income taxes, depending on where they are incorporated and operate. The corporate tax rate for the state of Wisconsin is currently 7.9%.
When a C corporation distributes profits to its shareholders in the form of dividends, those distributions are taxed as dividend income on the individual shareholder’s tax return. This creates a scenario known as "double taxation" – the company's profits are taxed first at the corporate level and then again at the individual level when the dividends are distributed to the shareholders.
C corporations can retain earnings in the company rather than distributing them as dividends, which can be a tax-efficient way to reinvest in the business. However, excessive accumulation of earnings can result in penalties when a corporation retains earnings beyond the reasonable needs of its business.
C corporations must file annual corporate tax returns (IRS Form 1120) and pay taxes at the corporate rate on their profits.
C corporations with net income for the year are required to pay quarterly estimates. These estimates are paid by the entity.
An S corporation is a special type of corporation that's designed to avoid the double taxation typically seen in C corporations. While it offers the same legal protections as a C corporation, its tax structure is more akin to that of a partnership or sole proprietorship. Here's an overview of the tax liabilities for an S corporation:
S corporations are pass-through entities, meaning the income, deductions, credits, and losses of the corporation pass through to the shareholders' personal tax returns. The corporation itself does not pay federal income tax.
The shareholders receive a schedule K-1 from the S corporation, reporting their share of the corporation's income or loss on their personal tax returns and pay tax at their individual income tax rates.
Shareholders who work as employees of the S corporation must receive a reasonable salary, which is subject to Social Security and Medicare taxes (FICA). However, S corporation shareholders are not subject to self-employment taxes on their share of the S corporation’s income and any profits that are distributed from the S corporation are not subject to self-employment taxes either.
This distinction makes it important to ensure that the salary paid to the shareholder-employee is reasonable for the work performed and not purposefully unreasonable to avoid paying self-employment tax.
In comparison to partnerships, S corporations have less flexibility in how they allocate income and loss to shareholders. To be eligible for S corporation status, the corporation cannot have more than one class of stock. This means that income, losses, and distributions from an S corporation must be made based on each shareholder’s ownership.
Similar to a partnership, distributions to shareholders of an S corporation are typically not subject to income tax as long as they do not exceed the shareholder’s basis in the S corporation.
Although the S corporation itself does not pay income tax, it must file an annual tax return using Form 1120S. This form reports the corporation's income, deductions, profits, losses, and tax credits.
Each shareholder receives a Schedule K-1 form from the S corporation, which shows their share of the corporation's income, deductions, credits, and other items. Shareholders use this information to complete their personal tax returns.
Some states recognize the S corporation status and offer pass-through taxation, while others do not and may tax the S corporation like a C corporation.
Depending on their portion of income from the S corporation, and their withholding, shareholders may need to make quarterly estimated tax payments to cover their tax liability.
S corporations generally must use a calendar year as their fiscal year unless they can establish a business purpose for a different fiscal year.
Also, in order to qualify for S corporation status, a corporation cannot have more than 100 shareholders.
The tax liabilities for a Limited Liability Company (LLC) can vary significantly based on several factors, including the number of members, the election of the tax status, and the jurisdiction in which the LLC operates. Here's a general overview:
By default, single-member LLCs are treated as "disregarded entities" for tax purposes. This means they are taxed similarly to sole proprietorships. The income and expenses of the LLC are reported on the owner's personal income tax return (IRS Form 1040), and profits are subject to self-employment taxes.
By default, multi-member LLCs are taxed as partnerships. The LLC itself does not pay income tax. Instead, profits and losses are passed through to the members, who report this income on their personal tax returns. Each member pays income tax on their share of the profits and each managing member will also pay self-employment tax on their share of the profits.
LLCs can elect to be taxed as an S corporation. In this case, the income is still passed through to the members, but it allows for some potential savings on self-employment taxes. Members who work in the business can be paid a reasonable salary, on which payroll taxes are paid. Remaining profits can be distributed and are not subject to self-employment taxes.
LLCs can also elect to be taxed as a C corporation. This means the LLC is taxed separately from its owners at corporate tax rates. Profits distributed as dividends to members are then taxed again on the members' personal tax returns, leading to double taxation. However, this option can offer benefits in terms of reinvesting profits back into the business and for certain tax planning strategies.
Tax Compliance and Complexity: Depending on the business’ circumstances, some types of entity structures can add complexity to the tax filing requirements.
Future Growth and Investment: Consider how the entity structure affects raising capital, attracting investors, and future business growth.
State-Level Implications: State tax laws vary, and the entity structure can have different implications at the state level than at the federal level.
Legal Liability and Formalities: Beyond taxes, consider the legal liability and the formalities required for maintaining the business structure.
Choosing the right business entity is a decision that can significantly impact your tax liability and overall business strategy.
If you are starting a business and wondering what entity structure is best or trying to determine if your current entity selection is right for your business, consult with a tax advisor or attorney to understand the full implications of each structure and tochoose the one that best aligns with your business goals and circumstances.
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Molly is a Manager with SVA and specializes in individual and corporate taxation with an emphasis on federal and multistate tax issues. In addition to tax preparation services, she works closely with clients throughout the year advising on tax planning opportunities and strategies.
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