Choosing a business entity classification for federal income tax — benefits and drawbacks of each
Whether you’re launching a new company, or you’ve been in business for 10 years, at some point, you selected – or will select – a business entity. This is simply an organizational framework that determines how you’ll be taxed, how your company operates its finances, and impacts what small business tax forms you’ll file.
The four types of entities for federal tax purposes are:
- Sole proprietorships
- C corporations
- S corporations
It’s important to note that a tax classification is different from a business entity, which is a state level entity you form. For example, an LLC at the state level doesn’t automatically assign a tax entity since an LLC is not recognized for federal tax purposes. Rather, the number of owners determines whether an LLC is a sole proprietorship or a partnership, unless it chooses to be taxed as a corporation.
Why is choosing the right business entity important?
Your business entity choice is one of the most important decisions you’ll make as you form your new venture. If you’ve been in business for a long time, you could assume that the one you chose at the beginning is still the optimal one for you. But as things change, it’s possible that reorganizing under a different business structure makes sense.
If you’re thinking about starting a business, your business structure will set a framework for your future operations.
There are a lot of factors to weigh, namely legal and tax. For legal insight, you’ll want to work with a legal professional. For taxes, you’ll want to have a good understanding of what tax implications are for certain business entities. If all of this sounds too consuming, get help.
Block Advisors is here to help you make sense the significant tax considerations for this important business decision. As part of your tax prep with of one of our small business certified tax pros, you can get insight into the potential impacts of different business entity tax classifications.
What is the best business entity for tax purposes?
Each type of business structure has its own set of rules that governs concerns such as your tax obligations, your company’s liability, ownership, and profits—so there’s really no umbrella “best” business entity for tax purposes.
Each business type has its advantages and drawbacks, which we’ve outlined here. However, this is an important decision, and what we outline in this article are only some of the many factors to consider. The information in this article is not intended to be legal advice or specific to any situation, and we recommend you seek the advice of an attorney about the implications of entity selection.
Our economy continues to proliferate with new business types for solo entrepreneurs. Many of these types of business owners establish their business as a sole proprietorship. This is the simplest type of business structure and the one most often employed by entrepreneurs who want to own and manage their own company. Anyone who makes money that isn’t reported on a W-2 form from an employer is a sole proprietor, whether or not they’ve incorporated.
Sole proprietors file their income taxes using the IRS Form 1040, the document familiar to anyone who has ever filed personal income taxes. They must file a Schedule C to report their business income and expenses — their profit or loss — which become a line item on the 1040.
Advantages of sole proprietorships:
It can be inexpensive to set up a sole proprietorship, and legal costs are usually limited to getting the necessary license or permits, plus insurance. And because there’s only one owner, that person has control over all the business decisions. Sole proprietors may be able to take advantage of the new deduction of 20% of qualified business income, which they can claim directly on Form 1040. Sole proprietors can also deduct 100% of their health insurance costs for themselves and their families as an “above-the-line” deduction on Form 1040.
Drawbacks of sole proprietorships:
Unlike individuals employed by a company, sole proprietors must pay all of their own income taxes. The IRS requires that they estimate the taxes due each quarter and make payments that would represent the taxes due for those three months. They must also file a Schedule SE with the Form 1040, which calculates the amount of self-employment tax that is owed for the year.
Sole proprietors must take responsibility for their company’s liabilities. And they may find it difficult to procure a business loan.
If you’re starting a business but are also thinking an LLC may be right for you, check out our article that outlines considerations for sole proprietorships vs. LLCs.
Corporations must file IRS Form 1120, among other forms, rather than Form 1040. All business activity is reported on this return and, unlike sole proprietorships, partnerships and S corporations, the C corporation pays tax directly on its net profits. Owners pay tax on the salaries and dividends they receive from the corporation on their individual returns at the appropriate tax rates.
Advantage of C corporations:
Corporations can raise money by selling stock. And they may be able to attract and retain the best and brightest employees who want the best benefits and the possibility of stock options.
Corporations are more complicated, but they don’t carry the personal liability for debts that sole proprietorships do because they’re separate legal entities, and not tied to an individual’s personal finances.
Drawbacks of C corporations:
But there is a major downside, other than the onerous paperwork and the administrative time: double taxation. Corporations must pay corporate income tax, and shareholders are required to pay taxes on dividends on their individual returns.
Also, because the laws and regulations governing C corporations are more complex and their administrative fees higher than those of a sole proprietor, they tend to be in place at larger companies with many employees.
If you’re thinking about starting a C corporation but question if LLC might be a better fit for you, check out our article that outlines considerations for C corps vs. LLCs.
Partnerships (multiple types)
Partnerships are automatically formed when two or more people want to pool their money and skills to build a business and share in its profits and losses. It’s something of an unusual business structure. Partners are not employees, and the partnership is not required to pay income taxes, though it must file an informational Form 1065, which reports income and deductions.
Profits or losses are “passed through” to the partners, who then receive a Schedule K-1 reporting the information the partnership files on its Form 1065. The K-1 reports the partners’ share of income and expenses. The partners file their own income taxes using Form 1040, and, like sole proprietors, they’re required to pay self-employment taxes and submit quarterly estimated taxes. Partners are also personally liable for the partnership’s obligations and debts.
If two partners in a partnership agree to split all items 50/50, each partner will receive exactly one-half of net income. In turn, the partners report the K-1 items on their individual tax returns. Like sole proprietors, general partners are usually subject to self-employment tax on their respective shares of net earnings.
Advantages of partnerships:
Partnerships are generally inexpensive and simple to set up, although more may be involved in setting up a Limited Partnership and other types of partnerships.
Usually, developing and negotiating the partnership agreement is the most time-consuming part.
Each partner invests in the business, so they can take advantage of the combined resources and complementary strengths of each partner. Partners are also potentially eligible for the new qualified business income deduction, which they claim on their individual tax returns. Partners may also claim the self-employed health insurance deduction.
Drawbacks of partnerships:
Similar to sole proprietors, general partners in a partnership have full, shared liability for their own actions and for the business’s actions.
General partners’ personal assets are not shielded from the business’s liabilities (a limited partner’s risk and liability is limited to his or her investment in the business). Limited Liability Company (LLC) owners are also shielded from the partnership’s liabilities. Learn more about LLC taxes.
While partnerships have the benefit of shared resources and responsibility, conflicts could arise. A detailed partnership agreement can help avoid or more easily resolve conflicts.
A domestic corporation (including an LLC that has elected corporate status) with no more than 100 shareholders and that meets certain other requirements can choose to be taxed as an S Corporation by filing Form 2553, Election Statement by a Small Business. An S Corporation has some of the properties of both C Corporations and partnerships.
Keep in mind, also, that an S and C Corporation are for a federal election – at the state level, if you choose either structure, you’re simply seen as a corporation.
Similar to a partnership, the corporation reports all income, deductions, etc., on the entity return, but passes them through to the shareholders via Schedule K-1 (Form 1120-S). Each shareholder’s share of these items is strictly based on the shareholder’s percentage ownership of the company. For instance, a shareholder who owns 75% of the company would receive 75% of net income, credits, etc.
Owners pay taxes on their distributive shares of corporate profits and on their salaries at their appropriate individual rates. Shareholders are required to pay themselves a “reasonable wage” and pay the employee’s share of Social Security taxes on their wages.
Advantages of S corporations:
Many small business owners favor the S corporation structure because of its tax benefits. This type of business entity has the same legal protections as a C Corporation. Unlike C corporations, after-tax profits distributed to shareholders aren’t generally taxed again as dividends at the individual level. So, S corporation owners avoid double taxation.
Like sole proprietors and partners, S Corporation shareholders are potentially eligible for the qualified business income deduction. Shareholders are also eligible to claim the self-employed health insurance deduction.
Drawbacks of S corporations:
Like a C Corporation, an S corporation must be incorporated at the state level, which can also be difficult and expensive.
The entity should elect S corporation status at the federal level at the beginning of its first year.
Also, like C corporations, S corporations must follow certain administrative procedures, such as scheduling specific meetings, keeping records, and maintaining bylaws.
Because shareholders pay FICA and Medicare taxes on their salaries (rather than self-employment tax), they are subject to IRS scrutiny regarding what constitutes “reasonable compensation.”
The IRS can reclassify after-tax distributions as W-2 wages in an audit.
If you’re considering an S corporation but are also thinking an LLC may be right for you, check out our article that outlines considerations for S corp vs. LLCs.
More help with business structure set-up
Hopefully this resource helped give you a framework to understand the different types of business entities.
In the end, your business entity choice has several significant implications, including corporate governance responsibilities, capital requirements, shareholder rights, and tax obligations. And each have their benefits and drawbacks.
Before making a final decision, you should get the advice of an attorney about the implications of entity selection.
Does this seem overwhelming?