It would be impossible to fully explain the intricacies of the various federal business tax regimes in a blog post. I can assure you, nobody wants to read that. However, I will attempt to briefly introduce some keep pieces of the following business tax regimes:
- Sole Proprietor (Schedule C of an individual return)
- C Corporation (Subchapter C - Form 1120)
- S Corporation (Subchapter S - Form 1120s)
- Partnership (Subchapter K - Form 1065)
If your business is conducted individually, without a business entity created pursuant to state law, it will be taxed as a sole proprietorship. Additionally, single member LLCs are taxed as sole proprietorships unless the member affirmatively elects otherwise. Practically speaking, the business income and expenses will be appear on a Schedule C attached to the individual's tax return. All income taxes will be paid by the individual business owner.
The main benefit of being taxed as a sole proprietor is simplicity. No separate tax returns will need to be filed. However, all income of the business will be subject to self employment taxes. Self employment taxes are likely the main reason small business owners opt for an entity taxed as a corporation. If a business is making enough money, the potential for tax savings can be great.
Once a business incorporates the default tax regime is Corporate tax under Subchapter C. The distinguishing feature of taxation under Subchapter C is the fact that the corporation will be taxed itself. The corporation will need to file a separate tax return (Form 1120) declaring income and deductions. Further, distributions of money and property from the corporation to shareholders will be taxable if coming from earnings and profits (E & P has its own meaning under the tax code, which I will be be digging into here).
The benefit of taxation under Subchapter C is that corporate rates can be lower than individual rates. So, for example, if the owner is paid a salary by the Corporation and excess profits are not distributed out to shareholders, that income could be taxed at a lower rate at the corporate level. However, if the corporation is losing money early on, those losses will not be deductible by the individual shareholders.
Corporations that meet certain criteria (for example, less than 100 shareholders) are allowed to elect S Corporation taxation (Subchapter S). This is done by simply filing a Form 2553, electing to be taxed as a small business corporation. Under Subchapter S, Income and losses flow through to the shareholders and are not taxed at the corporate level. The corporation will file a Form 1120S and issue K-1s to each shareholder.
The taxes on income from an S Corp must be paid by the shareholder regardless of whether those profits are distributed. However, when money and property are distributed to shareholders, this will only be taxable to the value exceeds "basis" (another tax code term of art that essentially reflects the shareholder's investment in the business). This results in there only being one level of tax on S Corporations.
Assuming the shareholder is paid a reasonable salary, the income that flows through on the Shareholders K-1 will not be subject to self employment taxes. This could result in a significant tax savings depending on how much income the business has. Further, if a business has losses early on, those will be deductible by the shareholder (subject some limitations).
Income from a Partnership (Subchapter K), like an S Corp, will flow through to the partners and be taxed at the individual level. Subchapter K taxation applies to Partnerships and is the default tax regime for multi member LLCs. Partnerships file an information return on Form 1065. The major difference with taxation under subchapter K is that all of a partner's income will generally be subject to self employment taxes.
The benefit of partnership tax is that the distributions of property to a partner is not a taxable event. This would make partnership tax a good regime for businesses that are holding significant property that will be appreciating in value.
While this was just a brief introduction to business taxation, hopefully I have provided enough basic knowledge to begin thinking about taxation of your new business. Business taxation can be a challenging subject to think about when starting a new business. It may be a good idea to speak to an attorney to determine which route is the best for your specific situation when getting started with a new venture.