Tax implications and reporting obligations for sole proprietorships, partnerships, S-corps, and C-corps
Key Takeaways
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Businesses owned by individuals are sole-proprietorships by default
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If you start a business with one or more other people, you’re automatically a partnership
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Profits from sole props and partnerships flow directly to owners who face self-employment and income tax on these amounts
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Sole props and partnerships can become single or multi-member LLCs
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An LLC separates the business from its owners on a legal level, but it doesn’t change the business’s tax structure
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S-corps pay owners a salary plus profits and owners pay income tax on both amounts, but they only pay self-employment tax on their salary
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C-corps must file a corporate return and pay 21% corporate income tax on their profits
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C-corps can pass dividends to their owners or shareholders, who face investment tax on those amounts
Your business structure determines how you are taxed and your reporting obligations. Before choosing a structure for your business, you should ensure you understand the tax implications, so you make the optimal selection.
In some cases, your setup dictates the type of business structure you need. In other cases, you have some flexibility. Take a look at your options and get a sense of what’s right in your situation.
A sole proprietorship is the simplest business structure, and you don’t have to do anything to set it up. If you are the only owner of the business, you are automatically a sole proprietor unless you set up another type of business structure.
For example, if you receive freelance income from clients, you are a sole proprietor. This applies to someone who does graphic design on a freelance basis and receives 1099 forms from a small handful of their clients. But it also applies to someone who provides mobile dog grooming services to hundreds of clients who pay in cash and don’t issue 1099 forms.
However, the sole proprietorship designation can apply to much larger businesses, as well. For example, if you open a brick-and-mortar restaurant or boutique and hire multiple employees, you can still be considered a sole proprietor.
Taxation of sole proprietorships
With this business structure, you report your income as business revenue and claim your business expenses against that amount. Then, you pay your personal income tax rate plus self-employment tax on the difference.
Self-employment tax consists of your Medicare premiums and Social Security contributions. When you’re employed, you pay half of these amounts, and your employer pays the other half. As a sole proprietor, you pay the full amount.
As of 2021, you face a 12.4% Social Security tax on the first $142,800 of your earnings. Earnings above this threshold don’t incur Social Security tax. The 2.9% Medicare tax applies to all of your earnings, and if you earn over a certain threshold, you may face an additional 0.9% Medicare tax.
For example, if you earn $1 million in revenue and you have $200,000 in expenses, you will be taxed on the difference of $800,000. That is your business profit. You report your business income by attaching Schedule C (Profit or Loss From Business) to your personal income tax return. You don’t have to submit a separate return for your business.
Limited liability company (LLC)
If you like, you can turn your sole proprietorship into a single-member LLC. However, this doesn’t change your tax structure. An LLC is a legal entity, not a tax entity.
You set up an LLC by filing paperwork with the Secretary of State. This process establishes your business as a separate entity from yourself. For example, if the business borrows money or faces a lawsuit, it is liable. You are not personally liable. Note there are exceptions to this rule depending on the situation and the contracts involved.
If your business has multiple owners, you can establish a multi-member LLC. Again, a multi-member LLC is a legal entity, not a tax entity, and it must file taxes based on its business structure from a tax perspective.
Partnership
A partnership is when two or more people own a business together. You don’t have to file any paperwork to create this business structure. For instance, if you and your partner decide to start a lawn care business together, you are automatically a partnership.
If you form a multi-member LLC, you remain a partnership for tax purposes unless you decide to become a corporation — more on that business structure below.
Taxation of partnerships
Partnerships are taxed the same as sole proprietorships, but the filing requirements are slightly different. Partnerships must file Form 1065 (US Return of Partnership Income) by March 15th. This is just an informational return. You detail your business’s income and expenses, and you explain how you’re divvying up your income and expenses between the partners. But you don’t have to pay anything.
Then, when you file your personal income tax return, you put the numbers from this form onto Schedule K-1 and attach it to your personal tax return. For example, if your 1065 says that your partnership has $200,000 in profits and you receive 40% of the profits, you report $80,000 as partnership income on Schedule K-1.
You face self-employment tax as explained above on your partnership earnings. And you also pay income tax on these amounts.
S-corporation
Both sole proprietorships and partnerships can opt to be taxed as S-corps. The appeal of this business structure is that it has the potential to reduce your self-employment tax. To be taxed as an S-corp, you must file Form 2553 (Election by a Small Business Corporation).
This form is due two months and 15 days from the date you start your business or the date you incorporate. However, if you have a current business and you want to change to this business structure, you must make the election by March 15 of the year you want the change to apply. The IRS will accept some late requests on a case-by-case basis.
Taxation of S-corps
Your S-Corp must file its own tax return by March 15. Use Form 1120-S (Income Tax Return for an S Corporation). Like the partnership return, this is just an informational return, and you should not submit payment.
When you file your personal tax return, you port the numbers from Form 1120-S onto Schedule K-1. If your business is international, you may need to use Schedules K-2 or K-3.
With a sole proprietorship or a partnership, the profits flow directly to you, and as explained above, you pay both self-employment tax and income tax on your profits. An S-corp works a bit differently.
When you set up an S-corp, the business pays you an income for your role. The income must be reasonable. You should not lowball this number to save on taxes.
Here’s how the numbers work: Imagine that you own a mechanic’s shop. Your business earns $200,000 in profits and you pay yourself a $50,000 yearly salary to be the manager of the shop. You face self-employment tax and income tax on the $50,000, but you only face income tax on the remaining $150,000 in profits.
The S-corp business structure shields a lot of your profits from self-employment tax. In this example, you’ve saved $22,950 in taxes. This is the $150,000 in profits times the self-employment tax rate of 15.3%.
If your S-corp has multiple owners, you will report all of their income and profits on the 1120-S, and then, each member will report their share of the earnings on their personal tax return. S-corp owners are considered to be shareholders, and you are allowed to have between one and 100 shareholders with this business structure.
C-corporation
A C-corporation is the most complicated business structure, and it is the only business structure that pays its own tax bill. If your business is a c-corporation, it must file Form 1120 (U.S. Corporation Income Tax Return).
If your corporation uses a calendar year, your return is due April 15th, the same day as your personal income tax return. Otherwise, the return is due by the 15th day of the fourth month after the end of your fiscal year.
Taxation of C-corps
You report all of the corporation’s income, gains, losses, deductions, and credits on this form, and it helps you figure out the business’s income tax liability. As of 2021, the corporate income tax rate is 21%. If your corporation has $1 million in profits, its income tax bill will be $210,000.
C-corps are owned by shareholders. This could be a single person or hundreds of people. For example, you could own 100% of the shares in your C-corp. If you and your four partners have an equal stake in the company, they would each be 20% shareholders. Alternatively, you could own 50% of the C-corp and sell the remaining 50% of the business’s shares to 50 different individuals who each own 1% of the company. Big companies like Apple have billions of shares and countless owners or shareholders.
Depending on your role in the company, you may be paid a salary. For tax purposes, this is the same as if you worked for another company. You pay half of your Social Security and Medicare payments, and the C-corp pays the other half. Then, you pay income tax based on your personal rate.
Additionally, the corporation may also pay you dividends. These are payments from the corporation based on your share in the company. You report the dividends as investment income on your tax return. You don’t have to pay any self-employment tax on these amounts, but depending on your filing status and income level, your dividends will be taxed at a rate of 0%, 10%, or 20%.
Your business structure determines the tax returns you need to file and the tax rates you’re likely to face. You don’t necessarily have to use the same structure for the life of your business. A lot of people start with a sole proprietorship or a partnership. Then, when they need additional legal protection, they turn the business into an LLC, and, eventually, they may opt to be taxed as an S-corp to reduce their self-employment tax burden. The business may even become a C-corp if it takes on more than 100 shareholders or wants to take advantage of other C-corp benefits.
Contact Franco Blueprint to talk about your business structure
Is your business structure the optimal option from a tax and legal perspective? Do you need help selecting the right business structure, establishing a business structure, filing taxes, or dealing with other essentials? Then, let’s talk.
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