Business Forms and Federal Tax Law

Navigating federal tax law is crucial for small business owners. Understanding different business forms and their tax implications helps in making informed decisions. From sole proprietorships to nonprofit corporations, each business structure has unique tax obligations. This includes business tax, self-employment tax, and corporate income tax. This article simplifies these concepts, aiding small business owners in effectively managing their tax payments, tax returns, and tax liability.

This overview provides some basic information on business forms and federal taxation. It's important to understand that each type of business structure carries different tax implications and options. For example, a limited liability company may choose to be treated as a corporation for tax purposes. It provides advantages in terms of deductions that a partnership tax status does not. Meanwhile, the owner's personal income taxes include federal taxes for a sole proprietorship. But sole proprietorships have their own limits.

This list should help you understand the basics and prepare you for a meeting with your attorney, who is equipped to help you decide what business form is best suited to your personal tax situation.

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Sole Proprietorship

A sole proprietorship is a business owned by a single individual. It's the simplest form of business, often chosen by new business startups. For tax purposes, the owner reports business income and business expenses on Schedule C to the Internal Revenue Service (IRS). This is part of their individual income tax return. This structure subjects owners to self-employment tax, covering Social Security and Medicare taxes. While sole proprietors enjoy full control, they also bear unlimited liability for business debts.

Here are the key features of sole proprietorships:

• Entity: It's not an entity separate from the owner, so there is no separate tax return
• Filing: The owner includes the operations of the sole proprietorship on their individual tax return
• Federal Employer Tax Number: If a sole proprietor has employees, a tax number is required
• Multiple Owners: No—if the business has multiple owners, it is no longer a sole proprietorship
• Taxable Year: Generally the same as the owner's, which is usually a calendar year

Partnership

Partnerships involve two or more individuals who co-own a business. They must file an annual information return to report the business income, deductions, gains, losses, etc., but the partnership itself doesn't pay income taxes. Instead, the income is “passed through" to the partners, who then report it on their individual tax returns. Partnerships can lead to complex tax situations, especially when partners have unequal shares or different types of contributions.

The key features of partnerships include:

• Entity: Not a separate taxable entity, but partners must file an information tax return
• Filing: Partners include their share of the income, gain, loss, deductions, and credits of the partnership on their personal tax return
• Federal Employer Tax Number: Required
• Multiple Owners: Requires two or more people who carry on a business for profit
• Taxable Year: If all partners do not have the same taxable year, the partnership will have to adopt the taxable year of majority interest or a calendar year if there is no majority interest

Keep in mind that there are different types of partnerships. Read FindLaw's Types of Partnerships article to learn more.

C Corporation

C corporations are traditional corporations subject to corporate income tax. They are taxed separately from their owners, leading to potential double taxation — once at the corporate level and again at the individual level when dividends are distributed. C corporations offer liability protection but have more complex tax preparation and reporting requirements. They may benefit from certain tax credits and tax deductions unavailable to other business entities.

• Entity: A taxable entity separate from its shareholders that may have an unlimited number of shareholders
• Filing: Corporations must file and pay taxes at the corporate level; the shareholders must pay taxes on the distributions they receive
• Federal Employer Tax Number: Required
• Multiple Owners: Usually, more than one shareholder
• Taxable Year: Can usually choose its taxable year

S Corporation

An S corporation is a special type of corporation designed to avoid the double taxation of C corporations. Income, losses, deductions, and credits flow through to shareholders. Shareholders then report them on their individual tax returns. The S corporation itself doesn't pay federal income tax. But it's subject to certain state taxes.

• Entity: Treated as a partnership for tax purposes but may not have more than 75 shareholders
• Filing: Shareholders include their share of the income, gain, loss, deductions, and credits of the corporation on their personal tax return
• Federal Employer Tax Number: Required
• Multiple Owners: Usually more than one shareholder but no more than 75 shareholders; they must be individuals, or the IRS will not treat the corporation as a partnership for tax purposes
• Taxable Year: Can usually choose its taxable year

Limited Liability Company (LLC)

An LLC offers liability protection like a corporation but with more flexibility in tax treatment. Owners, known as members, can choose to be taxed as a sole proprietorship, partnership, or corporation. This flexibility allows for efficient tax planning, but members must be cautious about accurately reporting business income and expenses to avoid audits by the IRS.

• Entity: It is not always a separate taxable entity but must file an information tax return
• Filing: Depending on its election, may choose to be taxed as a partnership or a corporation
• Federal Employer Tax Number: Required
• Multiple Owners: Not required. Every state except Massachusetts allows single-member LLCs
• Taxable Year: If members do not all have the same taxable year, the LLC must adopt the taxable year of majority interest or a calendar year if there is no majority interest

Get a Lawyer's Opinion About the Right Business Form for Your Company

Ultimately, the choice is yours. But sometimes, it's best to get advice and clarity from a legal professional before choosing something as important as a legal structure for your business. There are several considerations to make before deciding, including how your business will pay federal taxes. Talk to a business and commercial law attorney in your area to get started.

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