The 5 Most Common Business Entities and Their Tax Differences
One of the first choices that every entrepreneur must make about their new business is what type of business entity they will choose. Not only does the entity affect things like documentation and liability, but it also affects your tax bill. How does each major type change your tax obligations? Here are a few key things to know.
1. Sole Proprietors and Taxes
A sole proprietorship is the simplest way to form a business. The sole proprietor effectively is the business, and the entity is not legally distinguished from the person. This means all taxes are paid by the owner/operator rather than the business. Sole proprietors file business taxes on IRS Schedule C, which is part of their personal income tax return.
Sole proprietorships have an advantage in the simplicity of filing business and personal taxes together. However, you have added liability on a personal level. And you must declare all income as subject to income tax whether or not you withdrew money or needed the income.
2. Limited Liability Companies and Taxes
Because of the additional liability and tax responsibility of a sole proprietorship, many entrepreneurs opt for an LLC (limited liability company). In this business entity, you may choose to report business income and pay taxes on your personal income tax return (a pass-through entity) or be treated as though the business is incorporated.
If the LLC is taxed as a pass-through entity, each owner pays their share of taxes — which may or may not result in a lower overall tax rate than a comparable corporation. And the corporation pays no taxes of its own.
However, by choosing to be taxed as a corporation, the amount of taxes paid by an LLC owner can be lower than a sole proprietorship. One reason is that the company can declare retained earnings rather than pass all the income through to owners. Owners then only report what they actually took as income.
3. S Corporations and Taxes
An S corporation is a type of corporation specifically designed to be governed more like an LLC. Like an LLC, it can choose to pass income through directly to owners who report and pay taxes based on their personal tax rates (known as a pass-through entity). Owners whose personal tax rates are lower than the potential corporate tax rate stand to benefit from this option.
4. C Corporations and Taxes
C Corporations can only file taxes at the corporate level. The business pays income tax on its earnings. Then, owners of the corporation's stock report their own income as employees as well as dividends and other profits they receive. These are taxed upon each individual per their own responsibility.
The fact that the corporation pays taxes on its income and then owners pay taxes on what they receive is known as double taxation. This is the biggest tax downside of choosing a C corporation business entity or opting for corporate treatment for S corporations and LLCs.
5. Partnerships and Taxes
Partnerships' taxation looks a lot like the taxation of sole proprietorships. The partnership prepares its informational tax returns which stipulate how much income each partner must declare based on the partnership agreement. Each partner receives their report (known as Schedule K-1) and uses it to file their personal taxes. The partnership and other partners are not liable for these.
If your personal tax rate is low, you can benefit from this pass-through tax structure. However, as with a sole proprietorship, each partner is liable for their full share of income tax whether or not they actually used the income.
Where to Learn More
Want to know more about any of these business entities and their tax implications? Start by consulting with the team at Justice Law Idaho. We will help you assess each option and find the right entity for your needs. Call today to learn more.