Starting a business is hard and can be complicated, especially when you finally need to make it, “legal.” Part of getting right with the law is deciding on the right business entity, and broadly, the Internal Revenue Service recognizes several business types: the sole proprietorship, partnership, corporation S corporation and Limited Liability Company, which are state statute entities.
Tax treatment of sole proprietorships
In most states, sole proprietorships are the default, even if you do not file anything for your business. There is no separate entity, and all taxes and liabilities are your responsibility.
Tax treatment of partnerships
Partnerships are similar to sole proprietorships in that everything can also fall onto the partnerships, however, most states allow limited liability partnerships. However, the tax benefits and liabilities still pass through to partners. The partnership entity still must file an annual statement with the IRS that reports the entity’s income, deductions, gains, losses, etc., that flows to each partner, and a Schedule K-1 (Form 1065) to each partner. The partners then use their percentage on the Schedule K-1 on their own personal taxes.
Tax treatment of Corporations
Unlike partnerships and sole proprietorships, corporations are separate legal entities that are taxed separately. The profits are then distributed to the shareholders, who then pay taxes on those dividends. This means that corporate income is double tax as it is taxed at the corporate and shareholder level.
Tax treatment of S Corporations
S corporations, on the other hand, avoid this double tax. They pass on the corporation’s income, losses, deductions and credits to the corporation’s shareholders, who, in turn, then pay the IRS for this personally for federal taxes. However, there are strict criteria to qualify for S corporation status. First, the corporation must be domestic, have only shareholders that are estates, IRS allowable trusts, individual United States citizens, but they cannot be partnerships, corporations or non-citizens or aliens. There also cannot be more than 100 shareholders or more than one class of stock. Finally, the entity cannot be an IRS ineligible corporation, and it must file IRS 2553, Election by a Small Business Corporation signed by all the shareholders.