Business Tax Classifications

There are several different types of business tax classifications that you can choose from with the IRS. Which one you decide to implement will have a large effect on your taxes, so it is important that you understand how they all work. In this article, we will go over the four business classifications. These include sole proprietorship, partnership, S corporation, and C corporation.

Sole Proprietorship

A sole proprietorship is owned and operated by a single individual. The business is not separate from the owner, legally they are one entity. This means the business owner can be personally liable for any legal action taken against the business. For tax purposes a sole proprietorship is a pass-through entity. This means that profits or losses are all reported on the owner’s personal tax return. The taxes you pay on profits will be based on your individual income tax rate. However, you are also responsible for self-employment tax. This is the employer and employee portions of social security and Medicare taxes. If you want some additional protection, a single member LLC is also considered a sole proprietorship by the IRS.

Pros:

• Setup and operation are simple
• Tax filing is less complex
• You avoid double taxation

Cons:

• You can be personally liable for business debts
• There is a limited ability to raise capital
• You are subject to self-employment taxes

Partnership

A partnership is a business owned by two or more individuals. These individuals share in the profits and losses of the business. Partnerships file their taxes on Form 1065. Then the profits or losses pass through and are reported on the partners’ personal tax returns. From these the individual partner would pay taxes at their personal income tax rate as well as the additional self-employment tax. Multimember LLCs can file partnership tax returns as well.

Pros:

• Subject to few regulations when it comes to tax laws
• Not subject to double taxation
• Share the tax burden with your partners

Cons:

• Unless you have an LLC set up you will be personally liable for business debts

S Corporation

S corporation status is available to LLCs and partnerships. This status separates the business from the owners but avoids double taxation because they do not pay corporate income tax. If you elect S-Corp status you must pay yourself a salary, you will have to pay payroll taxes on those wages. To elect this status your company must be domestic and operating in the US. Additionally, all shareholders must be US citizens or permanent residents. The business cannot have more than 100 shareholders. Certain industries such as banks, insurance agencies, and import-export companies cannot elect to be S corporations.
Pros:

• Limited personal liability
• No double taxation

Cons:

• Complex tax rules
• IRS requirements can be limiting
• You are only able to issue one type of stock

C Corporation

If you are a C corporation you will be subject to double taxation. This is because you pay corporate tax on the business level. Then the owners and shareholders must pay tax on their share of the profits. However, these profits are not subject to self-employment tax. But if you receive a salary you will have to pay payroll taxes. This tax status is usually chosen by major corporations.

Pros:

• Limited personal liability
• You can issue stock to raise capital
• You are not limited on the number of shareholders you can have

Cons:

• There are complex rules and regulations
• You are subject to double taxation
• Can be expensive to establish

Choosing Between Business Tax Classifications

Which of the business tax classifications that you choose will depend on your personal circumstances. Meet with a tax advisor to explore the best options for your situation.

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