When choosing a form of ownership for your business, you have three primary options: sole proprietorship, partnership, and corporation. Many factors should go into the decision about which is best for a particular enterprise, including the potential tax ramifications.
Depending on your situation, there may be certain tax benefits to incorporation. Following is a closer look at the three primary types of entities and their potential impact on taxes.
Sole proprietorship is simply a business owned and operated by one person. The owner reports business income and expenses on a Schedule C, which is filed with Form 1040, and the profit or loss is combined with other personal income. If there are losses, they can generally be used to offset active nonbusiness taxable income.
Note that sole proprietor is subject to self-employment tax of 15.3 percent of net earnings, which are computed on Schedule SE. However, one-half of the self-employment tax is deductible as an adjustment to income on Form 1040.
Partnership is similar to a sole proprietorship but with two or more owners. Income and expenses flow through the business to the partners, who are taxed on income whether it’s actually distributed to them or not. Partners report business income and expenses on Schedule E and file it with their personal tax return. Like a sole proprietor, a general partner’s share of income is subject to self-employment tax, but a limited partner’s share generally is not.
This business entity carries its own legal status, separate and distinct from the owners. There are two types of corporations: regular (or C) corporations and subchapter S corporations. In a C corporation, taxes are paid by the business when they’re earned and then again by the shareholders when they receive distributions.
To avoid potential double taxation, a company may elect subchapter S status. Here, income and losses will pass through directly to the owner-shareholders, as they do with a partnership. The S election is made by filing IRS Form 2553.
A few limitations on S corporations may prevent a company from choosing this form of ownership. For example, S corporations may issue only one class of stock and they are limited to 100 shareholders (none of whom may be another corporation), and all shareholders must elect S status unanimously. However, S status is usually feasible for most small businesses.
When looking at the pros and cons of C and S corporations, also consider that certain items (e.g., company-paid health insurance for the owner and his or her family) are usually deductible for C but not S corps. There may also be potential tax ramifications in the conversion from a C to an S corp.
In addition, another type of organization is formed under state law: the limited liability corporation, or LLC (or LLP as it applies to partnerships). With this entity, profits and losses also pass directly through to shareholders, thus avoiding the potential double taxation of a corporation. The main benefit is that an LLC or LLP also protects the owner and partners from liability for the business’s debts and actions.
Note that an LLC is not a tax entity itself; rather, it allows the owner to choose which tax entity (sole proprietorship, partnership, or corporation) is preferred. From a practical standpoint, however, there are limited situations where an LLC would choose to be taxed as a corporation.
The tax issues involved in incorporation can be complex; therefore, consult an accountant for professional tax advice before deciding what type of business you will form.
Don Sadler is a freelance writer and editor specializing in business and finance.