Peter C. Lachance: Decide How Your Small Business Will Be Taxed

By PETER C. LACHANCE, CPA

Sunday, Feb. 1, 2009

Understanding and choosing how a small business is taxed is an important decision for business owners. The stakes are very high as an incorrect choice may prove costly to correct. By making the proper choice, a business owner can minimize taxes paid to Uncle Sam and put more cash in their pockets.

The Tax Entities

A Sole Proprietorship is a single owner tax entity. It is the simplest and easiest form of tax entity because it doesn’t require any legal organization or a separate tax return. Business income and expenses are reported on the owner’s federal tax return. In addition to federal income taxes, self-employment tax of up to 15.3% generally applies.

A Partnership is a multiple owner tax entity. A separate tax return is required; however, the owners pay federal income taxes on business income via their personal tax returns. This is called the pass-through taxation concept (more on this later). In addition to federal taxes, self-employment tax of up to 15.3% generally applies to owners who participate in the activities of the business. Partnerships allow for disproportionate allocations of tax items and distributions making it a very flexible tax entity compared to S corporations.

An S Corporation can be a single or multiple owner tax entity. A separate tax return is required however S corporations follow the pass-through taxation concept just like a partnership. Self-employment tax does not apply to pass through income. Reasonable wages must be paid to owners for services rendered to the business. These wages are subject to employment and income taxes. There are restrictions on the number and type of shareholders. Distributions of profits must be proportionate to ownership interests.

A C Corporation can be a single or multiple owner tax entity. A separate tax return is required. Owners of C corporations can experience double taxation, with profits taxed once at the entity level and again at the owner level when dividends are paid to owners. For small businesses, C corporations are seldom used because of the double taxation issue and the fact the IRS eliminated the C corporation’s biggest tax advantage by providing other tax entities and their owners with the ability to fully deduct certain fringe benefits.

Pass Through Taxation

One of the most misunderstood areas for new business owners is the pass through taxation concept. Essentially, the owners (instead of the business entity) pay federal income taxes on business net income. Owners receive a Form K-1 from the business that reflects their share of business income, deductions and other tax items that must be reported on their individual income tax return. Pass through taxation applies to Partnerships and S corporations

Legal Considerations

Most small business owners organize their business as a separate legal entity in order to protect personal assets and limit their liability. It’s important for these business owners to realize that the choice made for the legal structure of a business does not necessarily commit a business to a particular form of tax entity. For example, if a business owner wants to incorporate, then the C corporation or the S corporation are possible tax entity choices. The Limited Liability Company is a very popular legal structure in part because it can be taxed as a Sole Proprietorship, Partnership, S corporation or a C corporation depending on certain factors.

Formation Considerations

Frequently, the "business deal" will influence the choice of tax entity. For example, multiple owner small businesses can include owners providing the initial cash to fund a business (i.e. cash equity owners) while other owners will provide services in exchange for ownership (i.e. sweat equity owners). Further, the cash equity owners will want to be allocated all tax losses since their cash is at risk. In this instance, a partnership may be the preferred form of tax entity because it allows (and the Internal Revenue Code typically requires) the business losses to only be allocated to the cash equity owners. This special allocation would not be possible in a C or S corporation. In addition, partnerships do not require income to be recognized by the sweat equity owners for so called "profits interests" issued to them in exchange for services, as would generally be required in a C or S corporation.

Operating Considerations

New business owners should look into the future to the operating phase of a business and determine how their choice of tax entity will affect their business. For example, some small businesses anticipate incurring losses during its initial years. The ability to deduct these losses on the owner’s personal tax return could be a significant advantage, as it should provide tax relief for the owners of the business. C corporations do not pass tax losses or other items through to owners. However, sole proprietorships, partnerships and S corporations can provide their owners with the ability to deduct business losses on their personal tax return (limited to the owner’s investment or tax basis in the business).

Termination Considerations

Business owners will eventually sell their business and the form of tax entity plays a major role in how much cash will end up in an owner’s pocket. The taxation of the sale of a business is very complex and outside the scope of this article. However, in general, a C Corporation is the least desired tax entity because of double taxation. All the other forms of tax entities are generally more favorable and typically provide similar tax results from the sale of a business.

Making the Decision

As one can see, deciding on the best form of tax entity for a business requires in-depth consideration. Business owners should seek the advice of an attorney and an accountant before making this complex decision. As previously mentioned, the stakes are very high, as an incorrect choice may prove costly. Although changes can be made from one form of tax entity to another after the initial choice has been made, that change will require professional help and could trigger additional and unnecessary income taxes.

I look forward to answering your questions on this or any other tax topics.

To submit a question, use the form above or this link.