Choice of Entity – Part 2: Taxation

This is the second post of a three part series on the choice of  business entity. I previously posted on the asset protection advantages of different entity types. This post will focus on the tax advantages and disadvantages of those entities. The final post will address some their intangible qualities.

We can divide the tax treatment of business entities into two categories: pass-through and non-pass-through. Pass-through entities do not pay taxes directly.  Instead, their profits are allocated to the owners of the business. These profits are then included as income on the tax returns of the business owners to whom they were allocated. Non-pass-through entities, on the other hand, pay taxes on their profits directly. Now let’s take a look at which entities are pass-through, and which are not.

Sole Proprietorship

Sole proprietorship is simply a business form in which an individual works for himself. Sole proprietors include their business income and deductions on Schedule C of their individual Form 1040. This is a direct pass-through of taxation from the business to the individual.

Partnership

A partnership is a business form where two or more individuals conduct business together. Partnerships are pass-through entities, but unlike sole proprietors, they must file their own tax return. Partnerships file a Form 1065, which serves to calculate the profits or losses of the business. Attached to the 1065 is a Schedule K-1 for each partner, which allocates the profits/losses from the 1065 to that partner. For example, assume that I am a 50% owner of a partnership that makes a profit of $100,000 in 2011. The 1065 will state that there are profits of $100,000. My K-1 will look something like this:

Total Profits: $100,000
David’s Ownership: 50%
David’s Profits: $50,000

I will then have to report $50,000 of income on my individual 1040.

Corporations

Corporations have the option to choose their tax status, but their default treatment is non-pass-through. This default corporate type is called a C-Corporation, because it is taxed according to Subchapter C of the Internal Revenue Code. C-Corps file a Form 1120, which calculates their profits and losses. If there is a profit, then the corporation must pay taxes on the profit directly.

Alternately, the corporation could elect to be taxed under Subchapter S of the Code. This “S-Election” allows the S-Corp to file a Form 1120-S. The 1120-S calculates profits like an 1120, but includes Schedule K-1s like a partnership tax return. This allows the corporation to receive pass-through tax treatment.

Limited Liability Companies (LLCs)

Limited Liability Companies, like corporations, are able to elect their tax status. However, the default treatment for an LLC depends on the number of Members (owners). If there is only one member of the LLC, then it is treated like a sole proprietorship. If there are two or more members, it is treated like a partnership, and files a Form 1065 with Schedule K-1s. Instead, an LLC can elect to be treated like a corporation, and file a Form 1120. If an LLC elects to be treated like a corporation, it can further file an S-Election and achieve pass-through status. Clearly, LLC’s have incredible flexibility in structuring their tax treatment.

So Which One is Best?

Of course each entity has its nuances and peculiarities, so you shouldn’t select one without consulting an attorney. However, most practitioners agree that pass-through treatment is generally preferable to non-pass-through treatment. Here’s why. Non-pass-through entities are taxed on their profits at the entity level. They then pay dividends to their stockholders (owners). Those dividends are income, taxed to the individual stockholder on their Form 1040. The effect of this is that the profits of the business are taxed twice: once to the business, and once to the owner. Pass-through entities, instead, are only taxed at the individual level, resulting in generally lower taxes.

Let’s look at an example:

Assume that XYZ Corporation is a C-Corp owned by me, and that I receive the profits as a dividend. Also assume an individual and corporate tax rate of 25%, just to keep it simple.

Profits: $100,000
Corporate Tax: $25,000 ($100,000 x 25%)
Dividend to David: $75,000 (what’s left after corporate taxes)
Individual Tax on David’s Dividend: $18,750 ($75,000 x 25%)
David’s After Tax Income: $56,250

Now assume XYZ Corporation is an S-Corp (or partnership or sole proprietorship, or LLC)

Profits: $100,000
Corporate Tax: $0 (They pass-through on Schedule K-1 to me)
K-1 Income to David: $100,000
Individual Tax on David’s Income: $25,000 ($100,000 x 25%)
David’s After Tax Income: $75,000

In this scenario, electing pass-through tax treatment reduces my taxes by $18,750. That’s a whopping 18.75%.

Now that we’ve covered the Asset Protection and Tax considerations of choosing a business entity, can you see which entity I’m likely to recommend as a Massachusetts business planning attorney? Stay tuned for Part 3.

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