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Tax Implications To Consider When Choosing A Business Structure

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Tax Implications of the 4 common business structures

Choosing the wrong business structure can cost you a ton of money in overpaid taxes. Here are 4 common business structures and their tax implications.

When beginning a business, you must decide what form of business structure to establish. The business structure you choose influences everything from day-to-day operations, to taxes, to how much of your personal assets are at risk. You should choose a business structure that gives you the right balance of legal protections and tax benefits. In this article, we will go over the tax implications of the business structures according to the Internal Revenue Service (IRS). As far as the IRS is concerned, your form of business determines which income tax return form you have to file. The most common forms of business are the sole proprietorship, partnership, corporation, and S corporation. It is also important to note that a Limited Liability Company (LLC) is a business structure allowed by state statute and can elect to be taxed as a partnership or corporation.

1. Sole Proprietorships

Sole proprietorships are the most basic forms of business structure in the United States. It is the most simple and inexpensive type of entity to establish and maintain but has one major drawback; there is no legal separation between the business owner and the business. This means that the owner is personally legally and financially liable for the business. Usually, the owner is an individual, but it could also be a married couple. Business taxes are filed as personal income using Schedule C (Profit or Loss from a Business), which is submitted with IRS Form 1040.

It is also important to note that you’re automatically considered to be a sole proprietorship if you do business activities but don’t register as any other kind of business. Sole proprietors are still able to get a trade name also known as a Doing Business As (DBA).

Besides the fact the sole proprietor is held personally liable for the debts and obligations of the business, there are also other disadvantages to this type of business structure. For example, it can also be hard to raise money because you can’t sell stock, and banks are hesitant to lend to sole proprietorships.

Sole proprietorships can be a good choice for low-risk businesses and owners who want to test their business idea before forming a more formal business.

How Sole Proprietors Are Taxed

Sole proprietorships are considered a pass-through entity for tax purposes. This means that sole proprietors must report all business income or losses on their personal income tax return; the business itself is not taxed separately. Sole proprietors must list their business’s profit or loss information on Schedule C (Profit or Loss from a Business), which is submitted to the IRS along with Form 1040.

Notable Tax Implications For Sole Proprietors
  • Sole Proprietors are required to pay taxes on all profits: You’ll be taxed on all profits of the business — that’s total income minus expenses — regardless of how much money you actually withdraw from the business.
  • Sole Proprietors may deduct business expenses: You can deduct your business expenses just like any other business. You are allowed to expense (deduct) much of the money you spend in pursuit of profit, including operating expenses, product and advertising costs, travel expenses, and some of the cost of business-related meals. You can also write off certain start-up costs and the cost of business equipment and other assets you purchase for your business.
  • Sole Proprietors are eligible for TCJA personal deductions: Between 2018 – 2025, sole proprietors may also qualify for the new pass-through tax deduction established by the Tax Cuts and Jobs Act. Up to 20% of net business income earned by sole proprietors may be deducted as an additional personal deduction. However, sole proprietors with incomes over $315,000 (if married filing jointly) or $157,500 (if single) must have employees or depreciable business property to take this deduction and the deduction is limited to a percentage of employee wages or business property cost.
  • Sole Proprietors are required to pay estimated taxes every quarter: Because you don’t have an employer to withhold income taxes from your paycheck, it’s your job to set aside enough money to pay taxes on any business income you bring in during the year. To do this, you must estimate how much tax you’ll owe at the end of each year and make quarterly estimated income tax payments to the IRS and, if required, your state tax agency.
  • Sole Proprietors are required to pay Self Employment Tax: U.S taxpayers must contribute to the Social Security and Medicare systems. Employees do so through withholds from their paychecks and through payroll taxes paid by their employers. Because sole proprietors do not have an employer to withhold income taxes or contribute to the payroll tax, they must make their contributions when paying their other income taxes. These contributions are called self-employment taxes. According to the IRS, the self-employment tax rate is 15.3%. The rate consists of two parts: 12.4% for social security and 2.9% for Medicare. Sole proprietors can use Schedule SE (Form 1040 or 1040-SR) to figure out their self employment tax.

2. Partnerships

Types of Partnerships

Partnerships are the simplest structure for two or more people to own a business together. There are three common kinds of partnerships: limited partnerships (LP) and limited liability partnerships (LLP), professional limited liability partnerships (PLLC).

  • Limited Liability Partnerships: A partnership in which some or all partners have limited liabilities.
  • Professional Partnerships: The entity is formed by two or more professionals such as accountants, doctors, or lawyers, who provide professional services to the public.
  • Limited Partnerships: A partnership with a general partner (manages the business and has unlimited personal liability for the debts and obligations of the business) and a limited partner (limited liability and does not participate in management).
What Is The Partnerships Structure Best For?

A partnership is usually adequate for:

  • Business partners who do not intend to reinvest money back into the business
  • Multi-owner businesses with no employees
  • Multi-owner businesses providing products and services with minimal legal risks.
How Partnerships Are Taxed

Partnerships themselves are not actually subject to Federal income tax. Instead, they — like sole proprietorships — are pass-through entities. This means that all of the profits and losses of the partnership “pass through” the business to the partners, who pay taxes on their share of the profits (or deduct their share of the losses) on their individual income tax returns.

Filing Taxes For Partnership Income

Form 1065 and Schedule K: Even though the partnership itself does not pay income taxes, it must file Form 1065 with the IRS. This form is an informational return the IRS reviews to determine whether the partners are reporting their income correctly. The fourth page of Form 1065 is what’s known as Schedule K which is used to break down the partnership’s income into different categories.

Schedule K-1: The partnership must also provide a Schedule K-1 to the IRS and to each partner, which breaks down each partner’s share of the business’s profits and losses.

Form 1040: In turn, each partner reports this profit and loss information on his or her individual tax return (Form 1040), with Schedule E attached.

Notable Tax Implications For Partnerships
  • Partners are taxed based on allocated rather than distributed profit: This means that partnership profits are taxed based on allocated partnership profit share, even if nothing was distributed to partners.
  • Partnerships may deduct business expenses: Partners can deduct all of their legitimate business expenses from their taxable income. With a partnership, your deduction is for 20% of your share of the partnership’s profit, subject to limitations.
  • Partners must pay self-employment tax: Similar to sole proprietorships, business income from a partnership is generally subject to the self-employment tax in addition to income tax when it is passed through to general partners and it is reported on Schedule SE. Also note that the IRS allows partners to deduct half of their self-employment taxes from their taxable income. This helps balance out the fact that the partners generally pay double the amount of Social Security and Medicare that they would pay as employees because there is no employer paying the other half.
  • Partners must pay estimated taxes every quarter: Just like sole proprietorships, partners are required to make estimated quarterly tax payments to the IRS and to their state governments (if required) as well.

3. C- Corporations

Unlike sole proprietorships, a C Corporation (usually referred to as regular corporation). is a legal entity separate from its owners—all actions of the corporation belong to the corporation only. C-Corporations offer the strongest protection to its owners from personal liability, but the cost to form and maintain a corporation is higher than other structures. Corporations also require more extensive record-keeping, operational processes, and reporting.

Corporations can be a good choice for medium- or higher-risk businesses, businesses that need to raise money, and businesses that plan to “go public” or eventually be sold.

How C-Corporations Are Taxed

Unlike sole proprietors or partnerships, corporations pay income tax on their profits. In some cases, corporate profits are taxed twice — first, when the company makes a profit, and again when dividends are paid to shareholders on their personal tax returns, hence the common term “double taxation”. The corporation must file a Form 1120 each year to report its income and to claim its deductions and credits. Income earned by a corporation is normally taxed at the corporate level using the corporate income tax rates ranging from 15% to 39%.

Notable Tax Implications For C-Corporations
  • C-corporations offer more opportunities to minimize taxable income: C-corporation provides a myriad ways to reduce taxable income like no other business structure. For example, C-corporations may deduct salaries expenses, including payroll tax from their taxable income. Also note that shareholders are only taxed for corporate income (dividends) they actually receive instead of what’s allocated to them. Also, C-Corporations may carry losses over multiple years, enabling them to reduce taxable income for those years.
  • C-corporations offer more tax deduction opportunities: As a C corp, the business may be eligible for more tax deductions than if it were operated as an LLC, partnership or sole proprietorship. Such deductions may include charitable contributions, insurance premiums, fringe benefits et cetera.
  • Shareholders are taxed based on distributed rather than allocated profit: Unlike partnerships or S-Corporations, C-Corporation shareholders are taxed based on the actual amount they receive from the C-Corporation through distributed dividends. This feature allows shareholders to shift income readily and retain earnings within the company for future growth, usually at a lower cost than for pass-through entities.
  • C-corporation profits are taxed twice: Profits from C-Corporations are taxed at the corporate level, as well as at personal level when the remaining profits are distributed to shareholders as dividends; hence the term double taxation. However, C-Corporations have many ways to minimize, offset or avoid this “double taxation”, resulting in comparable or even favorable tax burden than the other business structures.

4. Limited Liability Companies (LLCs)

An LLC is a legal business entity offered in many states but does not have a tax status of it’s own with the IRS. From a legal perspective, an LLC lets owners take advantage of the benefits of both the corporation and partnership business structures. This means that LLCs protect owners from personal liability in most instances, your personal assets — like your vehicle, house, and savings accounts — won’t be at risk in case your LLC faces bankruptcy or lawsuits.

LLCs can be a good choice for medium- or higher-risk businesses, owners with significant personal assets they want to be protected, and owners who want to pay a lower tax rate than they would with a corporation.

How LLCs Are Taxed

A single-member LLC will by default be treated as a sole proprietor by the IRS for tax purposes. Multiple member LLCs owners may elect to be taxed as either a partnership or C or S Corporation. Here is how an LLC can elect a tax classification with the IRS:

  • C-corporation: An LLC is required to file Form 8832 to be taxed as a C-corporation, Entity Classification Election
  • S-Corporation: To be treated as an S-Corporation for tax purposes, an LLC is required to file Form 2553 to the IRS in addition to Form 8832.
  • Partnership: LLC owners do not need to file any other forms outside of the Form 22-4, Application for Employer Identification number in order to be taxed as a partnership.
Notable Tax Implications For LLCs

For the most part, the tax implications of an LLC depends on how it is regarded by the IRS for tax purposes. If the LLC is regarded as a partnership, then most of the procedures and benefits of partnership apply. For example, profits and losses can get passed through to your personal income without facing corporate taxes. The same is true for LLCs treated as S-Corporations or C-Corporation.

5. Special Case: S-Corporation

The S-Corporation isn’t a legal entity in itself but rather a tax entity for qualifying LLCs or C-Corporations. The IRS explains what criteria an LLC or corporation must meet to get S corp tax treatment. S-corporations tax entity serves two purposes:

  • Enable C-Corporations to avoid double taxation. Just like in a partnership, an S-Corporation’s profits and losses flow through to shareholders’ personal tax returns and are taxed (according to the shares of ownership) at the applicable individual tax rates. The corporate entity does not pay income tax as in a C-Corporation therefore avoiding the double taxation feature of C-Corporation. Shareholders who are employees of the S corporation only pay self-employment tax on the wages or salary that the corporation pays them. Dividend income paid to shareholders is not subject to self-employment tax; those monies are taxed as either ordinary income (at the individual income tax rates) or qualified dividends (at the capital gain tax rates).
  • Lessen the self-employment tax burden on LLC members. The primary advantage that LLC members gain by electing S corp status is that only income paid to LLC members on the payroll is subject to self-employment taxes. Profits paid as distributions are not subject to Social Security and Medicare taxes. Therefore, an LLC’s members may find that the S corp election will lower their personal tax burden.

S corps must file with the IRS to get S corp status, a different process from registering with their state. It is important to note that not all states tax S corps equally, but most recognize them the same way the federal government does and taxes the shareholders accordingly. Some states tax S corps on profits above a specified limit and other states don’t recognize the S corp election at all, simply treating the business as a C corp.

There are also special limits or qualifications on S corps. For example, S corps can’t have more than 100 shareholders, and all shareholders must be U.S. citizens. You’ll still have to follow strict filing and operational processes of a C corp.

S corps can be a good choice for a business that would otherwise be a C corp, but meet the criteria to file as an S corp.

S corporations are also somewhat more prone to IRS. audits And, if the IRS determines you aren’t paying yourself a reasonable salary, it may reclassify some dividends as earnings. Then you might owe self-employment tax plus penalty and interest on those.

Takeaways

  • Incorporating your business instead of operating as a sole proprietorship may reduce your tax burden.
  • Partnership or S-Corporation profits are taxed regardless of whether partners or shareholders receive their shares or not.
  • For tax years 2018-2025, partners or S-corporations shareholders can claim a deduction equal to 20% of their share of profits, subject to limitations.
  • Partners and sole proprietors must pay twice the amount in self-employment tax compared to payroll taxes paid by employees to cover Social security and Medicare.
  • C-corporations may have significant tax savings despite the double tax implications, especially if a business doesn’t regularly make distributions to owners in the form of dividends.
  • Since profits from S corporations and partnership income appear on taxpayer’s’ tax returns whether they have taken a distribution or not, owners can get bumped into higher tax brackets even though they plow profits back into the company.

Something Wasn't Clear?

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