Have you always dreamt of starting a business and are finally ready to make it happen? Whether it’s a product you created or a skill you mastered, turning your business plan into reality involves a few key steps to ensure your business is properly structured. In particular, appropriate entity selection can be key to the success of your business. This article will examine the tax consequences of several common business entity types: partnerships, corporations, and S-corporations. We will also briefly explore the use of limited liability companies, which may provide business owners more flexibility than traditional forms of business ownership.
A partnership is an entity with two or more owners. Partnerships, unlike other business forms, are not subject to tax at the entity level. Rather, the income generated by a partnership is generally passed through to its owners for tax purposes. The income and expenses are allocated to each partner on Schedule K-1, by agreed-upon percentages, and passed through to the individual partners. Each partner reports their share of the partnership’s annual activity on their personal tax return and the income is taxed at the individual’s marginal tax rate. The greatest benefit to a partnership is the ability to specially allocate items, which allows partners to decide on the distributions of income, expenses, and capital payouts, as long as certain requirements are met.
A corporation is a business owned by one or more shareholders and is considered an entity separate from its owners. As a result, the corporation files its own tax return and pays tax at the entity level. The earnings of the corporation may be distributed to shareholders in the form of dividends or can be retained for future growth. When a corporation distributes dividends to its shareholders, the dividend is taxed a second time as a capital gain to the shareholder. Even though double taxable is a disadvantage to corporate business form, corporations have other advantages, such as the ability to raise capital through public or private stock issuance.
An S-corporation is a corporation that has elected to be treated as a small business corporation for tax purposes. In order to make this election, a corporation must meet certain requirements including having 100 or fewer shareholders, having only one class of stock, and generally only having individuals as shareholders. The main effect of this election is that the S-corporation is taxed as a pass-through entity, like a partnership, rather than at the entity-level, like a corporation. Like partnerships, an S-corporation’s income and expenses are allocated to each partner on Schedule K-1, based on ownership percentages, and pass-through to the individual shareholders. Each shareholder reports their share of the S-corporation’s annual activity on their personal tax return and the income is taxed at the individual’s marginal tax rate. Since an S-corporation does not pay entity-level taxes, double taxation is avoided.
While S-corporations can avoid double taxation, pass-through taxation means that shareholders will be taxed on income as it is generated, rather than when it is distributed. Thus, shareholders may have a tax liability even when no distributions are received from the corporation. The strict requirements for S-corporations, coupled with the possibility of a tax liability without an accompanying distribution, may make an S-corporation a less attractive business option for some businesses.
The limited liability company (LLC) is a state law entity form that provides business owners with the greatest degree of flexibility. Essentially, the owner (or owners) of an LLC can ultimately choose how income from the LLC is taxed. In fact, an LLC can be taxed as entity disregarded from its owners, as a pass-through entity, or as a corporation. An LLC can even be taxed as an S-corporation. While there are varying rules on how to achieve these tax results based on the formation of the entity and its number of owners, in general, it is possible for business owners to achieve almost any tax result using an LLC. Due to this flexibility, the LLC has become one of the most common business entity forms to utilize when starting a business.
Ultimately, businesses have several options when deciding the most appropriate business structure. The entity type that is right for your business will depend on your specific business needs and your plans for the future. If you have any questions about these entities or need guidance while starting your own business, please contact your P&N tax advisor.
Lauren Fournier contributed to this article.