If you have recently or not so recently started a business, two things you need to understand is how you will be paid and how taxes will be paid. You may be taxed as a sole proprietorship, partnership, S corporation or C corporation. Understanding the differences is important.
A sole proprietorship is an individual engaged in a business without a formal tax structure. The net profit or loss from the business is reported on Form 1040 and is reported along with any other income. A net loss can offset other income reported on 1040. Self-employment tax is calculated on the net profit and is included on the 1040. Self-employment tax is basically Social Security and Medicare tax, both the employer and employee portion but is calculated using the net profit of the business from Schedule C.
A sole proprietor takes distributions from the business, which are not taxable, since tax is computed on the net profit from the business. A distribution is not a salary and has no federal or state withholding tax taken out. The owner will need to make estimated tax payments if the expected tax liability exceeds $1,000.
A partnership is a business with two or more members engaged in business. Partnerships file a Form 1065, which is an informational return, to determine how much income is allocated to each partner. The partners report the income or loss on their personal tax returns and, similar to the sole proprietor, must calculate self-employment tax.
Like the sole proprietor, partners can take distributions from the business. The distributions are not taxable since the partnership is taxed on its net profit. Partners may also loan money to the partnership and borrow money from the partnership.
Partners can also receive guaranteed payments which are not dependent on the net profit or loss of the partnership. Guaranteed payments are not subject to withholding.
An S corporation is a tax structure that can have one or more shareholders. It is often referred to as a “flow through” entity, which avoids double taxation. What this means is that the net profit or loss from an S corporation “flows through” and is reported on the shareholder’s tax return. The S corporation itself doesn’t pay income taxes and files a tax return that is purely informational. However, S corporations may be subject to filing state returns and paying other taxes such as franchise taxes.
Shareholders must receive “reasonable” compensation from the S corporation in the form of a salary. This is because net profit that exceeds the salary is not subject to Social Security and Medicare tax, which may incentivize shareholders to pay themselves lower wages or salaries. Reasonable compensation is very important to avoid having net profit re-characterized as salary if you are audited by the IRS.
Shareholders in the S corporation can also take distributions as long as there is enough tax basis to absorb the distribution. Tax basis is the amount of profit and capital contributions less losses and distributions. Distributions exceeding tax basis become taxable as capital gains on the shareholder’s personal tax return.
Loans to and from the S corporation are also permissible. Loans to the S corporation will increase tax basis, but need to be properly documented.
A C corporation is a tax structure in which the business is the actual taxpayer. This is different from the S corporation in the fact that there is no “flow through” from the C corporation to shareholders. Shareholders are compensated in the form of salary or wages. Any distributions taken from the C corporation are taxable as dividends to the shareholders. This entity creates double taxation: the corporation cannot take a deduction for dividends paid and therefore pays taxes on the profits used to pay those dividends, and shareholders are then taxed again on dividends received on their individual returns. However, this entity type might still be desirable for an individual who is in a higher tax bracket since a C corporation is taxed at a 21% flat tax rate.
Note that a Limited Liability Company (LLC) is a legal structure, not a tax structure. The default entity classification for an LLC is sole proprietorship if owned by one individual and partnership if owned by two or more individuals. There are elections available to treat an LLC as an S or C corporation for tax purposes – the owner(s) may need to file Form 8832 or Form 2553 to make the appropriate election, depending on the specific circumstances.
If you feel like your business could benefit from an entity evaluation or if you have questions about your taxes, please feel free to reach out any time.