Why Should I Care?
So, you've started a business. Maybe you've been in business for a while, and you're just now getting serious about making your business tax-efficient. Maybe you knew you were on top of the tax game in the past, but want to revisit in light of recent tax law changes.
The bottom line is that the way that your business is taxed may be the most important aspect of tax efficiency for businesses. The good news: you usually have a choice in how you are taxed.
Did you know, under current federal tax laws, the same business could be taxed in four different ways?
This article is not meant to be an exhaustive analysis in the differences between the four methods of business taxation. When I was in college, this topic was covered over the course of two semester-long classes. Instead, this article is meant to give you a brief overview of your options, and act as a springboard for further research. I've tried to include relevant resources where applicable.
There is one thing I'd like to point out before you get too far into this article: the legal structure and tax structure of a business can actually be different. I'll try to clarify some of these potential differences where I can, but I can't promise a confusion-free read.
I've attached some great charts from my deskbook that let you compare the different entities at a glance.
Sole Proprietorship:
My Thoughts:
Sole proprietorships, as the name implies, can have only one owner. In fact, they are the only kind of business that may not have more than one owner, with the exception of qualified joint ventures, which is a topic for another post.
If you've done much research, you know that you don't have to file anything to start a sole proprietorship. You just start operating the business, and the business is treated as indistinguishable from you for tax and legal purposes. You don't get the liability protection of some of the other forms of organization, but it's easy.
Many owners, seeking liability protection, will form an LLC. Many business owners think that putting property or a business into an LLC will change how they are taxed. This is not correct, the primary drivers of how a business is taxed are:
The number of owners
The legal structure of the business
The tax elections you have made or will make
In the introduction, I mentioned that that the legal form of a business can be different from the tax form. Enter the single member LLC (SMLLC). A SMLLC is by default taxed as a sole proprietorship. However, a SMLLC could elect to be taxed as a C-Corporation. C-Corporations can elect to be taxed as S-Corporations. If you were to add another member to the SMLLC taxed as a sole proprietorship, it would no longer be considered a sole proprietorship, as there would be more than one owner. In that scenario, the default tax form would become a partnership.
Confusing, right?
So what are the pros and cons of being a sole proprietor versus some of the other methods of business taxation?
Pros
You don't have to file a separate tax return, you just attach a "Schedule C - Profit or Loss from Business" with your normal individual tax return. This means you could potentially save money on tax prep fees.
You don't have to file any documents with your state or draw up legal papers of any kind.
The reporting requirements are less involved than other forms of taxation, meaning you could potentially save time on bookkeeping.
Certain deductions are easier to take for a sole proprietor, whereas a S-Corporation would require some additional hoop jumping. (Mileage, home office, self-employed health insurance premiums).
Cons
Sole proprietorships can be potential audit triggers, as they have historically been abused by those seeking to claim hobby losses or erroneous business deductions.
The entire profit is subject to self-employment taxes of up to 15.3% (See my article on taxes for the self-employed for help understanding what this means).
No liability protection (although you can compensate with insurance, or forming a SMLLC).
Federal Form to File:
Form 1040, with Schedule C
More Reader-Friendly Information:
More Information from the IRS:
Partnership:
My Thoughts:
Partnerships, by definition, have more than one owner. Similar to a sole proprietorship, you don't necessarily have to file any documents with your state to start a partnership. Two people going into business together creates a partnership. There are many types of partnerships: general partnerships (GP); limited partnerships (LP); limited liability partnerships (LLP); limited liability limited partnerships (LLLP).
If you have no separate legal entity and your business has more than one owner, your business is a partnership. If you have an LLC with more than one member, by default, that entity is treated as a partnership for federal tax purposes. See what happens here: a LLC is either by default a sole proprietorship if it has one member, OR a partnership if it has more than one member.
In the previous section, I mentioned an LLC can taxed in any of the four ways we discuss in this article. I want to draw your attention to another finer detail: legal partnerships are not eligible to be taxed as a S-Corporation or a C-Corporation. So what does this mean? A GP, LP, LLP, and LLLP must be taxed as a partnership. If you want to be taxed as a partnership, no problem. If not, or if you aren't sure, the LLC is more flexible for tax purposes.
One reason you might desire partnership tax treatment: debts of the partnership increase partner basis. Losses can be limited due to tax basis. So, in theory, a partnership with debt could allow you to deduct more losses at the individual level than any of the other business types here.
However, the actual mechanics of this are much more complicated, as there are currently five different business loss limitations, and all five can apply to the same business in the same tax year.
Partnerships and S-Corporations are both "flow-through" entities. That means they file their own tax returns, but they do not typically pay tax. Instead, they produce a Schedule K-1 that you will need to complete your individual tax return.
Practically speaking, the end result is frequently not that different from filing on Schedule C. Meaning, self-employment taxes are still in play (with the exception of limited partners). In fact, at the end of the day, you'll see this partnership business income reflected on Schedule E. Certain items like interest, dividends, capital gains, and charitable contributions (called "separately stated items") will be reported as if you incurred those items yourself.
Generally, this flow-through method of taxation will result in lower tax than if the business itself paid the tax (as in a C-Corporation).
Federal Form to File:
Form 1065
More Reader-Friendly Information:
More Information from the IRS:
S-Corporation:
My Thoughts:
The S-Corporation is probably talked about the most when it comes to business taxes. To be clear: I like S-Corporations, and they can result in significant tax savings. However, they do require more work, and a more professional approach from their owners.
There are numerous requirements imposed on S-Corporations, and violating them means that S-Corporation status is invalidated, meaning taxation would revert to a partnership or C-Corporation. This is usually really bad news, and we see court cases on this every year. The IRS has identified several areas that S-Corporations have been abused and will be expanding audits on these entities in the coming years.
So, I've scared you enough, here's some good news: S-Corporations can have between 1-100 owners (or more, with proper planning). You will have to have either a corporation or LLC and file an election with the IRS, but once it is accepted you're officially an S-Corporation.
The primary advantage of S-Corporation status is that the business earnings passed through on Schedule E are not subject to self-employment taxes. However, the officers must be paid reasonable compensation (i.e., paid through payroll, as an employee). So, in practice, what we actually see is a reduction in the amount of self-employment taxes paid. What reasonable compensation is has no clear answer and is frequently litigated in tax court.
The income is passed through in basically the same manner as we discussed for partnerships above. One exception: the losses may be limited since business debt does not generally increase basis. This is the primary drawback of S-Corporation status.
Federal Form to File:
Form 1120-S
More Reader-Friendly Information:
More Information from the IRS:
C-Corporation:
Analysis:
C-Corporations are the "vanilla" corporation. They are probably what you think of when you use the word "corporation." I'm thinking of Apple, Meta, and Berkshire Hathaway here. The S-Corporation came after the "C-Corporation" so to clarify and avoid confusion for people unfamiliar with tax law, tax practitioners frequently use "C-Corporation" even though the IRS and IRC never use the term.
C-Corporations can have as many owners as they like. A C-Corporation for tax purposes can be a corporation or an LLC that has elected to be taxed as a C-corporation. C Corporations pay a flat tax on their net income, and the distributions to shareholders (usually in the form of dividends) are taxed again at the individual level. This double taxation has been intentionally included in the tax code since the inception of the income tax. This means that most closely held C-Corporations' shareholders will pay more tax than any other form of business. This is generally true well into the upper middle class.
So, you have to make a ton of money to save on taxes with a C-Corporation. So why are people choosing this entity type? C-Corporations make it very easy to sell and exchange stock. An sale of an S-Corporation or Partnership interest can be very involved. As a result, most venture capital firms will only invest in C-Corporations. Raising capital is easier with a C-Corporation, and all the publicly traded companies on the major exchanges will be C-Corporations. (There are actually a few publicly traded partnerships, but that's a whole other can of worms).
Additionally, if the business has recurring losses, this can simplify the reporting during those loss years. So, sometimes, I'll see people start as a C-Corporation and then convert to an S-Corporation when the losses are all used up. This is the least common tax return I file.
Federal Form to File:
Form 1120
More Reader-Friendly Information:
More Information from the IRS:
So What Now?
Congratulations on making it this far, I know that was a ton of info, and that the material was dry.
However, I'm hoping you have gained an overview of why you might pick each of the entity types, or got access to more detailed information through the links I sprinkled throughout the article.
You'll notice that I haven't recommended an entity type at any point in this article. That's because there are so many factors that go into making a good recommendation. However, I'll offer up some general patterns I've seen in my practice.
Sole proprietorships are typically fine for small, single owner businesses and contractors grossing under $100k. DoorDash, Uber, and other gig work is usually fine to present on Schedule C.
Partnerships are a great option for real estate businesses and any multi-owner business where distributions are not uniform. If I have a business that won't follow all the S-Corporation rules, I will advise them to go the partnership route.
S-Corporations are a great option for businesses where the owner does most of the work (accountants, attorneys, doctors, dentists, architects, solo-subcontractors, etc.). They're also great for multiple owner businesses where distributions will be made according to ownership percentages. With a little work, the tax savings can be substantial.
C-Corporations are great for really large businesses, businesses with recurring losses, and those businesses looking to be acquired by venture capital funds.
No article is a substitute for good tax or legal advice, so it's always in your best interest to consult a professional. If you're needing help with your accounting or taxes, I'd love to meet with you and see if I can find a solution that makes sense for you or your business. You can book a time on my calendar here.
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