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If you have your own business, you have already gone through the process of deciding on a business structure. You know that the type of business entity you choose determines which income tax form you file and how you are paid by your business.
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Form a legal point of view, a "business entity" is defined as "any person or group of persons performing or engaging in any activity, enterprise, profession, or occupation for gain, benefit, advantage, or livelihood, whether for profit or not for profit."
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In the United States, the individual states incorporate most businesses. Very few special types are incorporated by the federal government.
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For federal tax purposes, the IRS has separate entity classification rules. Under the tax rules, a business may be classified as sole proprietorship, partnership, corporation, and S corporation. The IRS also recognizes a Limited Liability Company (LLC) as a relatively new business structure allowed by state statute. This newsletter’s purpose is to give you an insight into the tax implications of the different types of business entities as classified by the IRS.
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The IRS considers a sole proprietor as someone who owns an unincorporated business by himself or herself. A sole proprietorship is the easiest business to organize with minimal legal restrictions and formalities.
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| The sole proprietorship does not exist apart from the owner. The business comes into existence by the owner’s act of engaging in business transactions. The business ends when the sole proprietor stops engaging in business transactions. |
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| As a sole proprietor you do not receive a paycheck, instead you get a draw which is not a company’s expense, but reduces the equity you have in the company. You do not withhold any taxes on a draw, you pay a self-employment tax when filing your tax return. |
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| The self-employment tax includes the company portion of social security and medicare. As a sole-proprietor you don’t pay federal unemployment tax, but you should check with your state to see what their requirements are. |
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A sole proprietor files a 1040 U. S. Individual Income Tax Return, a Schedule C Profit and Loss from Business and a Schedule SE – Self-Employment Tax.
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| You may also be required to pay quarterly estimated tax. Any tax credits you may be entitled to are claimed on the sole proprietor’s individual income tax return. |
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If you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation.
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A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.
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The partnership as an entity can terminate if too much ownership interest is exchanged or liquidated within one year.
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A partnership must file Form 1065 which is an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes his or her share of the partnership's income or loss on his or her tax return.
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Partners are not employees and should not be issued a Form W-2. Individual partners receive Form K-1 and report their share of income and expenses on Schedule E, which is filed with their individual income tax returns, as well as Schedule SE for self-employment tax and quarterly estimated tax.
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| Any tax credits are claimed on the partner’s individual income tax return. |
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A C corporation is a legal business structure chartered by the state. Shareholders of the corporation contribute money, property or both.
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| For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. A corporation conducts business, realizes net income or loss, pays taxes and distributes profits to shareholders. |
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| The profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Shareholders cannot deduct any loss of the corporation. |
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| A corporation files a 1120 U. S. Corporation Income Tax Return and Form 1120-W for estimated taxes. C corporations use a separate tax rate schedule from that of individuals. |
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If a shareholder has received any dividends during the year, they will receive a Form 1099-DIV in January of the following year.
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| Shareholders who also perform services for the corporation are treated as employees of the corporation and are subject to all payroll taxes and reporting rules. Reasonable wages must be paid. Paying wages that are unreasonably high can avoid the double tax on dividend distributions and will likely be challenged by the IRS. |
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Losses do not pass through to shareholders and may be carried over to a year with profit, while capital losses must be carried over to a year with capital gains.
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Any tax credits are claimed on the corporation’s income tax return.
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S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
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| To qualify for S corporation status, the corporation must meet the following requirements: |
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- Be a domestic corporation;
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- Have only allowable shareholders
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including individuals, certain trusts and estates and |
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may not include partnerships, corporations or non-resident alien shareholders; |
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- Have no more than 100 shareholders;
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- Have only one class of stock;
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- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).
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| In order to become an S corporation, the corporation must submit Form 2553 Election by a Small Business Corporation signed by all the shareholders. |
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| The S Corporation files a Form 1120S U. S. Income Tax Return for an S Corporation. A Form 1120S Schedule K-1 is distributed to the shareholder. The shareholder may also receive a W2 if they received wages throughout the year. |
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| Liquidating a corporation is generally a taxable event, and liquidation proceeds received that represent contributions originally made in exchange for stock may be taxable. |
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Losses flow through to shareholders and can be used to offset other income, such as wages, interest, dividends, and capital gains.
Any tax credits are claimed on the shareholder’s individual income tax return. |
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| A Limited Liability Company (LLC) is a business structure allowed by state statute. Each state may use different regulations, and you should check with your state if you are interested in starting a Limited Liability Company. |
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Owners of an LLC are called members. Most states do not restrict ownership, and so members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single-member” LLCs, those having only one owner.
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| A few types of businesses generally cannot be LLCs, such as banks and insurance companies. Check your state’s requirements and the federal tax regulations for further information. There are special rules for foreign LLCs. |
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| Depending on elections made by the LLC and the number of members, the IRS will treat an LLC as either a corporation, partnership, or as part of the LLC’s owner’s tax return -a “disregarded entity”. A disregarded entity is a business entity that is separate from its owner but which elects to be disregarded as separate from the business owner for federal tax purposes. The only business type that fits all the qualifications to be a disregarded entity is a single-member LLC. |
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| Under these circumstances, there is not a specific tax return an LLC has to file. |
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For instance, a domestic LLC with at least two members is classified as a partnership for federal income tax purposes unless it files Form 8832 and affirmatively elects to be treated as a corporation. And an LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes (but as a separate entity for purposes of employment tax and certain excise taxes), unless it files Form 8832 and affirmatively elects to be treated as a corporation.
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| An LLC that does not want to accept its default federal tax classification, or that wishes to change its classification, uses Form 8832, Entity Classification Election, to elect how it will be classified for federal tax purposes. Generally, an election specifying an LLC’s classification cannot take effect more than 75 days prior to the date the election is filed, nor can it take effect later than 12 months after the date the election is filed. An LLC may be eligible for late election relief in certain circumstances. |
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| These are just some of the tax implications of different business structures. You should always make such decisions after having consulted your attorney and accountant. |
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