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 structure. This is simply an organizational framework that determines how you’ll be taxed, informs how your company operates its finances and impacts what small business tax forms you will file.

The four types of entities for federal tax purposes are:

  • Sole proprietorships
  • S corporations
  • C corporations
  • Partnerships

It is important to note that a federal tax classification is different from a business entity, which is created at the state-level. For example, an LLC (Limited Liability Company) at the state level doesn’t automatically assign a tax classification 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 for tax purposes, unless it chooses to be taxed as a corporation.

Why is choosing the right business structure important?

Your business structure 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 and advice, 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 structures. If the small business tax implications sound too consuming, Block Advisors can help!

For current clients who worked with a small business certified tax pro last year, much of the leg work is already done for you. Just reference the business structure analysis contained in your most recent tax return. Talk to your tax professional at your next appointment to see if your business could have a better tax outcome if it was structured differently.

If you’re just starting on the path of small business ownership, a good step is to learn more about business registration and entity tax classifications. Block Advisors has information and tools to help you learn more about this important step for your company.

What is the best business structure for tax purposes?

Each type of business structure has its own set of rules that address matters such as your tax obligations, liability obligations, ownership, and profits—so there’s really no umbrella “best” business structure for tax purposes.

Each business type has its advantages and considerations, many of which we have outlined here. However, deciding on a business structure is an important decision. What we outline in this article are only some of the many factors to consider.

Note: The advice and the products and services mentioned here are not a substitute for those of an attorney or law firm. This article provides general information that is not tailored to your particular situation. It should not be construed as legal advice. You may want to seek the advice of an attorney to evaluate all of the considerations and implications of business structure selection and entity formation.

Sole proprietorship

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.

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 Form 1040.

Advantages of sole proprietorships:

It can be inexpensive to set up a sole proprietorship. Costs are usually limited to fees for obtaining licenses, permits, and insurance premiums. Obtaining an EIN is free through the IRS. 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 deduction of 20% of qualified business income, which they can claim directly on Form 1040. Sole proprietors may also qualify to deduct 100% of their health insurance costs for themselves and their families as an “above-the-line” deduction on Form 1040.

Considerations of sole proprietorships:

Unlike individuals employed by a company, sole proprietors must pay all 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.

If a sole proprietor does not register their company as an LLC, they take personal responsibility for their company’s liabilities. Additionally, they may find it difficult to procure a business loan.

If you’re starting a business as a sole proprietor, consider if becoming an LLC is right for you. Check out our article that outlines considerations for sole proprietorships vs. LLCs.

S Corporations

A domestic corporation (or an LLC that has elected S-Corp 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 2553Election 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 corporation is a federal election – at the state level, you’re simply seen as the base entity you form, i.e. an LLC or corporation. Remember that filing requirements at the state level may vary.

Similar to a partnership, the S 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 S corporation profits and on their salaries at their appropriate individual rates. Shareholders that perform services for the business 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, profits distributed to shareholders aren’t generally taxed at the corporate 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 may also be eligible to claim the self-employed health insurance deduction.

Unlike a sole proprietorship, S corporation shareholders don’t have to pay self-employment taxes on their distributive share of the business’s income. This means that they are not required to file Schedule SE come tax time.

Considerations of S corporations:

An S corporation must be organized as an entity at the state level. This adds complexity and cost compared to becoming a sole proprietor.  If possible, the entity should elect S corporation status at the federal level at the beginning of its first year. While you can switch your choice at any time – you may not immediately see the full benefits of being an S corporation unless you choose it from the start.

For example, an LLC that wants to make an S corporation election after years of filing a Schedule C would have to make the election within a specific time frame. That is, for the business to get the tax benefits of being an S corporation, it must make the election anytime during the prior year or within the first two months and 15 days of the beginning of their tax year.

Also, like C corporations, S corporations that are corporations at the state level (except for those organized as an LLC) must follow certain administrative procedures, such as scheduling specific meetings, keeping records, and maintaining bylaws. This includes setting up a payroll system. Since an owner that performs services for the business is considered an employee of the S corporation, you must pay yourself a salary. That translates into needing a payroll system and staying up to date on quarterly payroll taxes.

It’s important to note that because shareholders pay FICA (Federal Insurance Contribution Act) 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 corporations vs. LLCs. While it is true that S corporations come with some added complexity at the start, structuring this way may save you a significant amount of money in taxes, depending on your profits and other factors. Once the change is complete, you can go back to business as usual.

C corporations

Corporations must file IRS Form 1120, among other forms, rather than Form 1040. All business activity is reported on this return. 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.

Advantages 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 because the company and the owner are separate legal entities there is less risk to the individual’s personal finances if they take the right steps in operating the company.

Considerations 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 corporations 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 qualified business income deduction, which they claim on their individual tax returns. Partners may also be eligible to claim the self-employed health insurance deduction.

Considerations of partnerships:

Like 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 (while a limited partner’s risk and liability could be limited to his or her investment in the business).

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.

More help with business structure set-up

Hopefully, this resource helped give you a framework to understand the distinct types of business structures.

In the end, your business entity choice has several significant implications, including governance responsibilities, capital requirements, owner rights, and tax obligations. And each has its benefits and things to watch out for.

Before making a final decision, you may want to seek the advice of an attorney to evaluate all of the considerations and implications of business structure selection and entity formation. It is also a good idea to speak to a Block Advisors certified small business tax pro about your unique tax situation.

Still overwhelmed by business structures?

While there are multiple small business considerations, let Block Advisors empower you with resources to help you make a more informed decision. Learn more about Block Advisors’ business formation products and services.


 

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