Different Types of Businesses and How They Are Taxed

Determining which type of business is right for your situation can be difficult. There are several things to consider when making this decision. Taxes play an important role in this choice and the type of business entity that works will depend on several factors such as the size and structure of the company being formed. Below is a quick introduction to the different types of business entities and how they are taxed.

Sole Proprietorship

A sole proprietorship is a business structure that involves only one owner but may have employees. The owner is solely responsible for the assets and liabilities of the business. Therefore, the sole proprietor will report business income and related taxes directly on their personal tax return, Form 1040 under a Schedule C, at their individual federal income tax rate. From a tax standpoint, this type of business is simple as there are no separate taxes for the business. The sole proprietor will also be required to pay self-employment taxes, which are contributions to Social Security and Medicare that regular employees normally have taken out of their paycheck (generally referred to as ‘payroll taxes’).

Partnership

A partnership can be formed when two or more people own a business together. Partnerships are like a sole proprietorship for more than one person, except that instead of having the business’ income and expenses reported directly on each partner’s personal tax return through the Schedule C, they flow through to each partner’s personal returns via the Schedule K-1. Each partnership should have an operating agreement that details how the business’ profits and losses should be allocated to each partner. Partnerships file their own separate tax return, Form 1065. Additionally, partners in a partnership, or any other type of passthrough entity (LLCs and S-Corporations, see below) may be eligible for the Qualified Business Income (QBI) deduction.

Limited Liability Company (LLC)

A limited liability company, or LLC, is a business structure that is taxed as a pass-through entity much like partnerships. It can be formed by one or several members and is unique from a tax standpoint as it can elect to be taxed as a partnership or a corporation. Additionally, from a legal standpoint, an LLC is a separate entity from its members and therefore offers liability protection to them. This means the individual assets of LLC members cannot be used to satisfy the debts and obligations of the LLC and any losses are limited to the amount that members have invested in the business. Ultimately, how the business is taxed depends on how the LLC decides to be treated. An LLC with at least two members is taxed as a partnership unless it elects to be taxed as a corporation. An LLC with only one member is considered a disregarded entity for tax purposes and is taxed as a sole proprietorship. One drawback of the LLC structure is that a member of the LLC is NOT permitted to also be a W-2 employee of the LLC. Members’ compensation must either come in the form of guaranteed payments, which are subject to self-employment taxes, distributions, or a combination of both.

C-Corporation

A C-Corporation is a separate legal entity from the owners of the business. The profits of the business are taxed at the entity level under the business name, using Form 1120. The main drawback of the corporate structure from a tax standpoint is the concept of “double taxation,” which refers to how the income of the business is taxed at the entity level, and then the subsequent dividends paid out from that income is taxed at the shareholder level. Dividends are taxed on the shareholder’s personal tax return at ordinary or capital gains rates, depending on whether or not the dividends are qualified. Corporations have liability protection for their shareholders but also have several reporting and document maintenance requirements. For example, corporations are required to create and file Articles of Incorporation in the state they are formed, may need to have corporate bylaws which outline the regulations of the business, and may also be required to file annual reports or franchise tax returns to states in which they are incorporated or registered to do business. One common example is that Delaware corporations must file an annual report to the state of Delaware by March 1st of each year, along with a tax payment that is dependent on the corporation’s asset and equity levels.

S-Corporation

An S-Corporation is like a C-Corporation, except that it elects to have pass-through tax-treatment and files a Form 1120-S. S-Corporations have liability protection but also have certain formation requirements and stock ownership restrictions. In order for a business to qualify as an S-Corporation, it must have no more than 100 shareholders, its shareholders may only consist of individuals and certain trusts and estates, and they may NOT consist of partnerships, corporations, or any non-resident alien shareholders. Additionally, S-Corporations are required to allocate income and pay out distributions on a pro-rata basis based on each shareholder’s ownership interest. Like a partnership or LLC, an S-Corporation’s income and losses will flow through to the shareholders’ personal tax returns via Schedule K-1, at least for Federal income tax purposes. There are some state jurisdictions, such as DC, which do not recognize S-Corporation status and will tax the entity like a C-Corporation at the entity level. If the shareholder performs services for the business, then they may be considered both an employee and an owner from a tax perspective. In which case, they would need to be paid a reasonable salary and report that income on a W-2 form and take the rest of their compensation as distributions. Characterizing compensation as salary or distributions in an optimal and reasonable fashion can help reduce the shareholder’s self-employment tax liability.