This is part of a series of posts on the tax implications of different business entity types.
Types of Business Entities and Tax Implications Various factors affect the choice of the form of business organization.
Business owners can choose among several different forms of organization with different tax and other legal consequences to each of them. They can operate as a:
- Sole proprietor (no explicit or formal business organization);
- Partnership (which can take several different forms, such as a limited partnership or limited liability partnership);
- Limited liability company or LLC;
- S corporation1; or
- C corporation.
In choosing the type of organization for their business, owners will balance tradeoffs among simplicity, legal protection, access to capital, taxes, and other factors. The focus of this information brief is on tax issues; however, the box at the right identifies some nontax factors that affect the choice of entity.
Different tax requirements apply to each type of entity or organization.
C corporations report and pay tax at the entity level—through the federal corporate income tax and Minnesota corporate franchise tax—while the other businesses’ tax is paid at the individual level. Sole proprietorships report and pay income and self-employment tax directly on the owner’s individual return. S corporations must file informational business returns and also report income from the business to the shareholders on a separate schedule. The owners then report the income and also pay self-employment tax on wages paid for services they provide to the business at the individual level. Partnerships can elect to be taxed as corporations (called “checking the box”); if they don’t elect to be taxed as a corporation, then their income is reported and taxed on their owners’ individual income tax returns, with the full amount of income reported subject to self-employment tax. LLCs, like partnerships, can elect to be taxed as corporations; those that do not “check the box” may choose to report either as a partnership or as a sole proprietorship. Generically, S corporations, partnerships, and multimember LLCs that haven’t “checked the box” (i.e., LLCs choosing to report as partnerships) are referred to as “pass-through” entities, because their income and its tax consequences are “passed through” to their owners’ personal tax returns.
C corporation income is taxed annually at the entity level, but is not taxed at the individual level until it is distributed as dividends or until stock is sold and capital gains realized. Businesses that choose not to pay dividends may retain income for business growth without individual income tax consequences to the owners/shareholders.
The income of S corporations and partnerships (including LLCs reporting as partnerships) is recognized as distributed to the owners/shareholders or partners annually for tax purposes, even if the income is retained within the business. In that situation, the shareholders’ pro-rata shares of income are still reported to them and they must pay income tax on the income, even though they never actually received it. This is sometimes referred to as “phantom income.” Business owners in this situation adjust their basis in the entity upward by the amount not distributed.2 This will result in their realizing smaller gains (and paying less tax) if they sell their shares in the entity. In practice, most pass-through entities typically distribute at least enough income to their owners to cover the federal and state tax due on that income.
Table 1 summarizes the tax treatment of the different forms of business.
|Sole proprietorship||S corporation||Partnership||C corporation|
|Social Security and Medicare taxes apply to||Net profit||Compensation of officers, directors, and other employees||Net profit||Compensation of officers, directors, and other employees|
|Federal and state income tax applies to||Net profit||Net profit plus compensation of officers and directors||Net profit||Compensation of officers and directors and dividends paid|
|Federal and state corporate tax applies to||N/A N/A||N/A||3 Net||profit|
Two major differences in the taxation of the different business entities are:
- the amount of income subject to Social Security and Medicare taxes and
- the effective double taxation of net profits of C corporations.
S corporations pay self-employment tax for Social Security and Medicare only on amounts paid to their shareholder/owners as wages, while sole proprietorships and partnerships pay self-employment tax on their net profit. This is a prime advantage of forming an S corporation, since it allows business owners to minimize their liability for the self-employment tax.4 A partnership must report and its partners pay self-employment tax on the net business income of the partnership, while an S corporation does so only on the amount paid to employees as wages. If shareholders elect to pay themselves modest wages and treat most of the earnings as business income, much of the self-employment tax is avoided. In some cases, this may be questioned and recategorized by the Internal Revenue Service if the wages paid are not reasonable, relative to the value of the service provided. However, according to some accounts, the Internal Revenue Service typically challenges these arrangements only if owners pay themselves little or no salary.5
C corporations, including LLCs and partnerships that “check the box,” must pay tax on the business’s income twice to use it for personal purposes. C corporations are subject to federal corporate income tax and Minnesota corporate franchise tax on their net profits, and then these profits are taxed again when paid to shareholder/owners as dividends, or when the shareholders sell the stock and realize capital gains. In contrast, net profit of proprietorships and pass-through entities is taxed only once.
This “double” taxation of C corporations creates an incentive for businesses with significant profits to operate as pass-through entities, whenever possible. Publicly traded companies—i.e., corporations whose stock is traded on a stock exchange—generally operate as C corporations. Conventional wisdom is that newly formed businesses opt for direct taxation as a proprietorship or pass-through taxation to avoid this double taxation, unless they plan to “go public” within a short period of time. Businesses typically choose between operating as an S corporation or LLC, taxed as a partnership.
There are other important differences in the taxation of the different types of pass-through entities. Most tax professionals think partnerships have a number of important tax advantages over S corporations, putting aside the differences in Social Security and Medicare taxation. A somewhat more comprehensive (but still very simplified) catalogue of the varying tax treatment of different forms of business entities is provided in Appendix A. However, the fact that more businesses choose to organize as S corporations than as partnerships suggests that the self- employment tax advantages for S corporations may be a deciding factor in the choice of business form.
Table 2 compares the amount of tax paid by a business with $100,000 of net profit ($80,000 of which is really compensation for services provided by the owners or officers) for different business entities.
|Sole proprietorship||S corporation||Partnership||C corporation|
|Compensation of officers||$80,000||$80,000|
|Self-employment or FICA tax||$14,130||$12,240||$14,130||$12,240|
|Federal and MN income tax on wages/distributed profits*||$32,050 $32,||050||$32,050||$25,640|
|Federal and MN corporate tax||N/A||N/A||N/A||$4,960|
|Tax on C corporation dividend to shareholder**||N/A N/A||N/A||$4,410|
|Total tax liability||$46,180||$44,290||$46,180||$47,250|
|* Assumes federal rate of 25% and Minnesota rate of 7.05%. ** Assumes 15% federal rate and 7.05% Minnesota rate.|
For the S and C corporations, $80,000 of the net profit is assumed to be paid to the owners/shareholders as wages, with the remaining $20,000 reported as business income. The S and C corporations pay less in payroll taxes than do the partnership or sole proprietorship, since payroll taxes only apply to the $80,000 paid the owners in wages. The owners of the sole proprietorship and the two pass-through businesses pay state and federal income tax on the full $100,000, regardless of whether it is paid as compensation to the officers and reported as wages or flows through and reported as business income. The owners of the C corporation are subject to payroll taxes only on the $80,000 of wages, like the S corporation. In addition, the remaining $20,000 of net profit is subject to federal corporate income tax and Minnesota corporate franchise tax of $4,960. Table 2 assumes this $20,000 is paid to the owners as dividends, subjecting it to additional federal and state income tax of $4,410. This is the “double taxation” of corporate profits that makes organizing a business as a proprietorship or pass-through entity attractive from a tax perspective.
Appendix B provides tax calculations for a two-owner S corporation, including the effects for S corporation shareholders of basis adjustments from pass-through income.
Nontax Factors That Affect the Choice of Entity
- Protection from legal liability. Corporations, limited liability companies, and some types of partnerships offer more legal protection than sole proprietorships or regular partnerships. A sole proprietor or a general partner is individually liable for any actions or failures of the business. In contrast, the liability of a corporation, limited liability partnership, or LLC is limited to the business assets.
- Ease of operation. A sole proprietorship is the simplest business entity, since it requires taking no formal action. Most small businesses don’t bother forming an entity and report their income as proprietors. Forming one of the business entities requires registering, electing officers, holding regular meetings, maintaining entity records, and so forth.
- Access to capital. Although the choice of entity does not affect access to debt capital (such as bank borrowing or selling bonds), generally a business must be a C corporation for its stock to be traded on a stock exchange.
The content of this and any related posts has been copied or adopted from the Minnesota House of Representatives Research Department’s Information Brief, Taxation and Small Businesses in Minnesota, written by legislative analysts Nina Manzi and Joel Michael.
This post is also part of a series of posts on the tax implications of different business entity types.
1 These letter designations of “S” and “C” refer to the subchapter of the Internal Revenue Code that contains the rules for taxing these entities.
2 Pass-through entities and their owners must keep track of two forms of basis (the tax cost that is a key in determining gain, loss, and various other tax calculations). In very simplified terms, “outside basis” refers to the owner’s (S corporation shareholder, partner, or LLC member’s) basis in his or her share of the entity and that determines the owner’s gain or loss on disposition of all or part of his or her ownership (e.g., sale of S corporation stock). By contrast, “inside basis” is the basis on the books of the entity and will generally determine the gain, loss, and allowable depreciation of the entity (S corporation, LLC, or partnership) for its transactions and activities. The tax attributes that result from the inside basis are, though, ultimately reported to and determine tax on the owners’ individual returns.
3 This assumes that the partnership (or LLC) does not “check the box” and elect to be taxed as a C corporation.
4 C corporations and their employees are subject to FICA taxation on employee wages. This imposes a combined tax burden essentially equal to the tax under the Self-Employment Contribution Act (or SECA) on employees of S corporations.
5 Walter D. Schwidetzky, “Integrating Subchapters K and S – Just Do It,” Tax Lawyer 62, no. 3 (Spring 2009): 798–801 (discussing cases).