Taxation and Your Entity Choice

  

  

So now you know that there are several entity choices available to business owners. It’s also important to note that the legal form that you choose can make a big difference in the taxes you pay and how they are paid. 

 

A Sole Proprietorship is owned and operated by one individual.  The net business income is reported and taxed to the owner on Schedule C of the owner’s personal income tax return. Although income taxes are not withheld on business income as it’s earned, quarterly estimated taxes may be required.  The sole proprietor pays income tax at their regular income tax rate plus self-employment tax on the net earnings of their business (with an income tax deduction for 50% of the self-employment tax paid).

 

A Partnership is a separate entity consisting of two or more partners.  The partnership files an information tax return (Form 1065), but pays no income tax at the partnership level.  Rather, the income or losses are passed through (via Forms K-1) to the partners, who report them on their individual Form 1040s based on their agreed-upon profit/loss percentages.  Like the sole proprietor, the partners also pay self-employment tax on net income from the partnership, (unless it results from rental real estate activities).

 

Corporations: A corporation is a distinct legal entity apart from the shareholders who own it.  The C Corporation (a “regular” corp) files its own tax return (Form 1120) and pays its own income tax. If the shareholders work in the business, then the corporation must pay them reasonable wages and withhold payroll taxes on those wages. Although the corporate tax brackets start out low (15% on the first $50,000 of taxable income and 25% on the next $25,000), the rates jump up to 34% and more after the first $75,000 in taxable income.  With the C Corp, there is also the very real potential for that dreaded “double taxation” of earnings – income is taxed once at the corporate level and again at the shareholder level when paid out as dividends or as a liquidating distribution. If your business is a professional service organization (i.e. attorney, architect, physician, CPA), then a C Corp is considered by the IRS to be a Personal Service Corporation and is taxed at a flat 35% on all taxable income.

A Corporation can elect to be taxed as an S Corp if it meets certain qualifications.  Once the S Election is made, the corporation generally does not pay its own income tax.  The S Corp files a Form 1120S and distributes Forms K-1 to its shareholders, who then report their pro rata share of income, losses, and credits on their individual tax returns and pay income tax at their own tax rates.  Thus, the double taxation that regular corporations face is avoided with an S Corporation.  Another advantage is that the flow-through income of the S Corp is not subject to self-employment tax.

 

A Limited Liability Company combines the general flexibility and income tax treatment of a partnership with the limited liability of a corporation, which makes it very popular for certain types of businesses.

 

This has been a brief overview of just the income tax aspect of owning a business.  Most businesses are also subject to a variety of other taxes, such as Combined Excise taxes, payroll taxes, personal property taxes and various other city and local taxes depending on the business location.  Consulting with competent advisors before you start your business will give you the knowledge and tools you need to help make running your business less “taxing” and more successful.

 

 

Short bio for Jan Stockton: 

 

"Jan Stockton has been a CPA in Vancouver since 1987.  Her practice focuses on tax planning and preparation for small businesses, individuals, trusts and estates with an emphasis on helping her business clients run their businesses more profitably."