How Are Different Business Entities Taxed?

There’s a lot that’s great about owning a business: Being your own boss. Engaging in an industry you’re passionate about. Being able to say you built something on your own.

Then there’s the taxes.

Once you enter the world of entrepreneurship, taxes can get a lot more complicated. Granted, taxes are just one of many factors that will play into your business strategy, but knowing how different business entities are taxed can help you decide what kind of company you want to start or eventually evolve into.

Below, we’ve put together a cheat sheet on how income is taxed based on the legal structure of your business. Of course, we’re just scratching the surface. You’ll want to consult a tax advisor to get a thorough understanding of which type of entity is the right choice for you, including how other types of taxes — such as self-employment taxes — are handled within each kind of business. That said, consider this your jumping off point.

Sole proprietorship

Being a sole proprietor means you own and run your business by yourself; your business is not a separate legal or tax entity. So you and your business are one and the same from the IRS’ point of view, which means any assets and liabilities are reported by you on your personal 1040 income tax return. This is the simplest form of taxation for the self-employed.

Because a sole proprietorship is considered a “pass-through” business — meaning the business income passes through to the owner and is taxed at his or her ordinary income tax rate — sole proprietors may be able to deduct up to 20 percent of their qualified business income. This was introduced as part of last year’s tax-law changes.

However, determining whether you qualify for this deduction can get complicated. It depends not only on the amount of pass-through income you make, but also on the type of business you have; here’s some guidance from the IRS to help you figure out whether your business qualifies.

In a nutshell, all pass-through business owners can take an up to 20 percent deduction on their qualified business income (QBI) if their total taxable income falls below a certain taxable income level ($160,700 for single filers and $321,400 for married filing jointly). Above that amount, however, and it gets tricky. If you own a business in a service field (like law, health, accounting, the performing arts, financial services, or any business where the principal asset is the skill or reputation of its employees) you can get a limited deduction. But once your taxable income surpasses $210,700 for single filers and $421,400 for married filing jointly, you won’t be eligible for the deduction anymore (engineering and architecture firms are the exception).

If you own a non-service business, you still may be able to take a deduction beyond that income limit, but it’ll be the lesser of the following calculations:

• 20 percent of your QBI, or

• The greater of 1) 50 percent of your W-2 wages or 2) 25 percent of your W-2 wages plus 2.5 percent of your qualified property cost (i.e., the cost of certain real estate or equipment you own).

Confused yet? That’s why it’s important to talk to a tax professional to help you determine if you qualify for this deduction. Things can get especially unclear if your business has both a service and non-service component to it.

Partnership

When two or more people plan to own a business together, they may choose to form a partnership. Partners generally have a partnership agreement that outlines details like how you’ll share profits and losses and make contributions to the business. The partners may also have to register their business with their state; state laws will determine the rights of partners as it pertains to their participation in management and the extent of their liability.

Despite that, from a tax perspective, your partnership is not a separate taxpaying entity. It does have to report its income, deductions, losses and other information to the IRS by filing a Form 1065, but a partnership allocates its profits and losses to its partners, who report it on their individual tax returns and pay tax on it. The partners may also qualify for the QBI deduction of up to 20 percent of the income they make from the partnership.

Limited liability company (LLC)

A limited liability company, or LLC, can also be taxed as a pass-through entity. An LLC can be formed by an individual or group of individuals, also known as members. It is a separate legal business entity from its members. Technically, there is no such thing as being taxed as an LLC. Unless an election is made with the IRS, an LLC with one member is taxed as a sole proprietorship, while a multi-member LLC is taxed as a partnership. An LLC can elect to be taxed as a C corporation or an S corporation, if it qualifies as such.

A business owner or owners might choose to form an LLC in order to retain the pass-through income status that sole proprietorships or partnerships have, while also having some of the liability protection of a business entity. Apart from the tax considerations, an LLC has fewer statutory requirements and formalities that need to be followed than a corporation, and more flexibility than a partnership when it comes to managing the business.

S Corporation

A corporation can also have pass-through tax treatment, if the business elects to be taxed as an S corporation. To become an S corp, however, you must meet certain qualifications. S corps also need to file form 1120S to report information like income, deductions, profits and losses to the IRS.

There are several differences between an S corp and other pass-through businesses, however. One of them is that an owner who performs services for the business is considered both an employee and an owner from a tax perspective — and must be paid a reasonable wage compared with standards for that profession. That means business owners would report some of their income as W-2 employee wages, and some as the share of profits they received as an owner. Having income split up this way could ultimately help a business owner save in self-employment taxes. Other major differences include rules around shareholder rights and how debt is treated, so make sure you’re considering everything before deciding on becoming an S corp.

C Corporation

A corporation that doesn’t elect to be taxed as an S corporation is taxed as a C corporation. A C corporation is a completely standalone tax entity from the people who own the company. Although a C corp has shareholders, profits are taxed separately under the corporation’s name, so it does not constitute a pass-through business (a corporate tax return is filed using form 1120). A C corp can, however, still share profits with its owners.

This means that the profits from a C corporation are taxed twice. The corporation itself pays taxes at the flat 21 percent corporate tax rate (although most corporations end up paying a smaller effective tax rate after deducting expenses). Then, when profits are shared with the company’s shareholders as dividends, those are taxed on the shareholder’s personal income tax returns (either as ordinary income or as capital gains).

Of course, taxation is just one piece of the puzzle when it comes to starting or growing a business, and your business’ structure may change over time along with your needs. To get a deeper understanding of the right tax strategies for your business, talk to a tax advisor who has experience working with business owners. A financial advisor can also help you see how your business and personal financial plans work together to meet your personal financial goals.

This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.