There are four different types of tax treatment available for business entities, they are: sole proprietorship tax treatment, partnership tax treatment, S corporation tax treatment, and C corporation tax treatment. You get to choose which type of tax treatment you want. This is one of the most important business decisions you’ll ever make because there are big differences among the available choices. For example: if you choose S or C corporation treatment, you’ll be your practice’s employee and have to have your income and Social Security taxes withheld from your salary. In contrast, you’re not an employee if your practice receives sole proprietorship or partnership tax treatment. Nothing is withheld from your pay, so you’ll have to pay estimated taxes four times a year. There are also important differences as to how profits can be allocated among a group practice’s owners, how losses can be deducted, and even the likelihood of an IRS audit. These and other differences are compared below. First, you need to understand how the different forms of tax treatment work. This post provides overview for each type of the for tax treatments, illustrated with case examples.
Tax Treatment Choices
Whenever a business entity is created or comes into existence, it automatically receives a form of tax treatment by default. However, except for sole proprietorships, business entities have some leeway to change from their default treatment to another type of tax treatment.
A multi-owner LLC, LLP, or partnership is automatically taxed as a partnership by default, but may choose to be taxed as a C corporation or S corporation. This is easily accomplished by filing a document called an election with the IRS. Once this is done, as far as the IRS is concerned, the LLC, LLP, or partnership is now the same as a corporation and it files the tax forms for that type of entity. However, the great majority of LLC s, LLP s, and partnerships stick with their default partnership tax treatment.
Corporations are taxed as C corporations by default, but may change to S corporation tax treatment by filing an S corporation election. This is extremely common. A one-owner LLC is taxed as a sole proprietorship by default but can elect to be taxed as a C or S corporation by filing an election. This is not common, however. The sole proprietorship is the only entity that can’t change its tax treatment—it must retain the sole proprietorship taxation treatment that it receives by default.
The table below shows all the choices available for each type of entity.
Type of Entity Tax Treatment Choices
Sole proprietorship Sole proprietorship taxation
Partnership, LLP, Partnership taxation; or
Multi-owner LLC Partnership taxation; or
C corporation taxation; or
S corporation taxation
One-owner LLC Sole proprietorship taxation; or
C corporation taxation; or
S corporation taxation
Corporation C corporation taxation; or
S corporation taxation
Let’s discuss each of the tax treatment. Read on…
Tax Treatment For Sole Proprietorship
When you’re a sole proprietor (or single-member LLC with sole proprietor tax treatment), you and your business are one and the same for tax purposes. Sole proprietorships don’t pay taxes or file tax returns. Instead, you must report the income you earn or losses you incur on your own personal tax return (IRS Form 1040). If you earn a profit, the money is added to any other income you have—for example, interest income or your spouse’s income if you’re married and file a joint tax return—and that total is taxed.
Although you are taxed on your total income regardless of its source, the IRS still wants to know about the profitability of your business. To show whether you have a profit or loss from your sole proprietorship, you must file IRS Schedule C, Profit or Loss From Business, with your tax return. On this form, you list all your business income and deductible expenses. If you have more than one business, you must file a separate Schedule C for each one.
Example: Irene is a sole proprietor dentist with no one else in her practice. This year, she had $250,000 in dental income and $150,000 in expenses, giving her a $100,000 profit. She files Schedule C with her personal tax return (IRS Form 1040) listing the expenses and income from her practice. She reports her $100,000 profit on her Form 1040 and pays personal income tax on it, as well as Social Security and Medicare taxes. To figure her taxes, she adds her dental income to any other taxable income she has for the year for example, investment income—and pays taxes on it at personal tax rates.
Sole proprietors must use the sole proprietor form of taxation. If a sole proprietor wants a different type of tax treatment, he must form a business entity such as a corporation or LLC.
In addition, LLC s with one owner are automatically treated like sole proprietorships for tax purposes. However, they have the option of switching to a C or S corporation taxation.
Tax Treatment For Partnership
The next basic form of business taxation is partnership taxation. This form of taxation applies to partnerships, LLP s, and multimember LLC s. When they are first formed, these entities all automatically use partnership taxation; and the great majority continues to use it throughout their existence. However, they have the option to switch to other forms of taxation.
Under partnership tax treatment, the business entity is a pass through entity for tax purposes—that is, it ordinarily pays no taxes itself. Instead, the profits, losses, deductions, and tax credits of the business are passed through the business to the owner’s individual tax returns. If the business has a profit, the owners pay income tax on their ownership share on their individual returns at their individual income tax rates. If the business incurs a loss, it is likewise shared among the owners who may deduct it from other income on their individual returns, subject to certain limitations.
Unlike a sole proprietorship, a partnership is considered to be separate from the partners for the purposes of computing income and deductions. The partnership files its own tax return on IRS Form 1065. Form 1065 is not used to pay taxes; rather, it is an information return that informs the IRS of the partnership’s income, deductions, profits, losses, and tax credits for the year. Form 1065 also includes a separate part called Schedule K-1 in which the partnership lists each partner’s share of the items listed on Form 1065. A separate Schedule K-1 must be provided to each partner. Each partner reports on his individual tax return (Form 1040) his share of the partnership’s net profit or loss as shown on Schedule K-1. Ordinary business income or loss is reported on Schedule E, Supplemental Income or Loss. However, certain items must be reported on other Schedules—for example, capital gains and losses must be reported on Schedule D and charitable contributions on Schedule A.
Example: Irene decides to join her dental practice with her friend Lie’s dental practice. They practice together as general partners. The partnership earns $500,000 in income in one year and has $200,000 in deductible expenses. The $300,000 annual profit the partnership earns is passed through the partnership to Lie and Irene’s individual tax returns—each gets 50% of the profit or $150,000. They each must pay personal income tax on their share of the profits. Their profit is added to any other income they have and is taxed at their individual tax rates.
Tax Treatment For S Corporation
S corporations are taxed much like partnerships. Like a partnership, an S corporation is a pass-through entity—income and losses pass through the corporation to the owners’ personal tax returns.
S corporations also report their income and deductions much like partnerships. An S corporation files an information return (Form 1120S) reporting the corporation’s income, deductions, profits, losses, and tax credits for the year. Like partners, shareholders must be provided a Schedule K-1 listing their shares of the items on the corporation’s Form 1120S. The shareholders file Schedule E with their personal tax returns (Form 1040) showing their share of corporation income or losses.
No business entity starts out with the S corporation form of taxation. Instead, you must obtain it by filing an election with the IRS. The most common way to obtain S corporation taxation is to form a regular C corporation and then file an election to be taxed as an S corporation with the IRS . This simply involves filing IRS Form 2253 with the IRS.
However, S corporation status is allowed only if:
- the corporation has no more than 100 shareholders
- none of the corporation’s shareholders are nonresident aliens—that is, noncitizens who don’t live in the United States
- the corporation has only one class of stock—for example, there can’t be preferred stock giving some shareholders special rights; and
- none of the corporation’s shareholders are other corporations or partnerships.
These restrictions apply whether you form a C corporation and change it to an S corporation, or form an LLC, LLP, or partnership and elect S corporation tax treatment. They do not pose a problem for the vast majority of professionals.
The other way to obtain S corporation status is to form a partnership, LLP, or LLC and file an S corporation election with the IRS. This isn’t usually done because professionals who have LLC s, LLP s, or partnerships usually prefer their default partnership tax treatment. However, if you already have an LLC, LLP, or partnership, and S corporation tax treatment sounds attractive to you, you should consider filing an S corporation election. But see a tax professional before making this important decision.
Tax Treatment For C Corporation
Under the C corporation form of taxation, the business is treated as a separate taxpaying entity. Profits and losses do not pass through to the owners’ individual tax returns as they do with the sole proprietorship, partnership, and S corporation forms of taxation. Instead, C corporations must pay income taxes on their net income and file their own tax returns with the IRS using Form 1120 or Form 1120-A.
In effect, when one or more professionals form a C corporation, they create two or more separate taxpayers—the corporation and themselves, the shareholders. This separate tax identity has both advantages and disadvantages.
A C corporation pays income tax only on its net profit for the tax year, and it pays this at its own corporate tax rates, not the personal tax rates of its owners. It gets to deduct from its income all of its ordinary and necessary business expenses, including employee salaries, most fringe benefits, bonuses, and operating expenses like office rent.
However, dividends distributed to the shareholders are not deductible (which, in theory, can lead to double taxation—see “Double Taxation” in the “Tax Rates” section below).
C corporation shareholders don’t pay personal income tax on income the incorporated business earns until it is distributed to them (as individual income) in the form of salary, bonuses, or dividends. They also don’t get to deduct the corporation’s business expenses on their personal returns. They belong to the corporation.
Example: Jeremy forms a C corporation—Jeremy, Inc.—to own and operate his medical practice. He owns all the stock in the corporation. The corporation takes in $500,000 in income. It pays out $300,000 in operating expenses and salaries for Jeremy’s employees, and pays Jeremy a $100,000 salary. Jeremy, Inc. had a net profit for the year of $100,000 ($500,000 income – $400,000 expenses = $100,000 net profit). It must pay taxes on its profit at the applicable corporate tax rate. Jeremy, Inc., files its own tax return and pays the tax from its own funds. Jeremy, the individual and employee of Jeremy, Inc., must file his own personal income tax return and pay income taxes on his $100,000 salary at individual income tax rates.
All corporations are initially taxed as C corporations and stay that way unless they file an election to be taxed as an S corporation with the IRS. In addition, partnerships, LLP s, and LLC s can elect to be taxed like C corporations. This is not commonly done, but is an option you should consider if you already have an LLC, LLP, or partnership and would like to obtain the benefits of C corporation tax treatment without going to the trouble of actually forming a corporation. See a tax professional first, however, because once you choose C corporation treatment it may be prohibitively expensive to switch back.