Many factors determine the full tax burden on a business. Some of these factors – such as treatment of capital gains, deductibility of certain items, and the availability of certain credits – will vary depending on the form of organization.
Other factors, such as employment taxes attributable to non-owner employees or property taxes, will apply regardless of the form of organization. For detailed analysis of these factors in the context of the specific business, a competent tax advisor should be consulted. The following paragraphs describe the major differences in tax impact attributable to the form of organization.
Net income or loss from the business is combined with the proprietor’s income and losses from other sources to determine the proprietor’s income for tax purposes.
The proprietor is taxed on the net income of the business, regardless of whether the income is withdrawn for personal purposes or retained in the business. Because income or loss from the business is combined for tax purposes with income and losses from other sources, the tax impact on income from the business may be different than if the business were taxed as a separate entity.
However, because only the proprietor and not the business entity is taxed, there is no double taxation on profits of the business paid to the owner. Another advantage of the sole proprietorship compared with the C corporation is that not only the amount but the character of various income items, deductions, and credits may be claimed by the business owner. In a C corporation, items are claimed by the corporation on its tax return and are not passed through to shareholders.
Partnership income is taxable to the partners regardless of whether it is actually distributed or retained in the business.
The partners report their distributive share of partnership income, deductions and credits on their individual income tax returns, where these items are combined with income and losses from other sources. This income is taxed at the individual income tax rate applicable to the partner’s tax bracket.
The partners may allocate their distributive share of partnership income, deductions and credits for tax purposes in the partnership agreement. So long as there is “substantial economic effect” to the allocation (as defined by tax laws and Internal Revenue Service regulations), the partnership may offer greater opportunity for tax planning than the proprietorship or corporate form of organization.
By “substantial economic effect” the Internal Revenue Service essentially means that the allocation made in the partnership agreement may actually affect the dollar amount of the partner’s share of the partnership income or loss independently of any tax consequences.
As with the proprietorship, both the amount and character of various income and deduction items are passed through to shareholders. However, certain deductions may not be permitted, certain items must be separately stated, and a partner’s ability to claim his or her share of partnership losses generally is limited to the partner’s adjusted basis in the partnership.
C corporations are separate taxable entities. The C corporation’s taxable income, and tax, are determined prior to distribution of profits to shareholders. Profits which are distributed to shareholders in the form of dividends are then taxable to the shareholders at their individual income tax rate. Thus these dividends are subject to double taxation: once on the corporation’s income tax return and once on the individual shareholder’s income tax return.
In addition, the dividends are taxed to the shareholder as ordinary income: capital gains, charitable contributions and other income and deduction items do not retain their character when passed to shareholders in the form of dividends. Similarly, individual shareholders do not share a corporation’s losses for tax purposes.
C corporations offer some opportunity for tax planning in that dividends may be accumulated by the corporation rather than paid to shareholders, thus postponing double taxation. However, Internal Revenue Service regulations limit the amount of accumulated earnings that may be retained by the corporation.
An accumulated earnings tax may be imposed on excessive accumulated earnings. Because all income of the sole proprietorship, partnership, and S corporation is taxable to the owners whether or not it is distributed, these entities are not subject to the accumulated earnings tax.
The C corporation also may pay a salary to owner-employees. Salaries are deductible by the corporation and thus are not included in the corporation’s taxable income. However, the Internal Revenue Service may treat as dividends excessive salaries that appear designed to avoid double taxation.
Like a partnership, the S corporation is a conduit through which the firm’s income and deductions flow to the shareholders. Income items (including capital gains) and deductions generally retain their character when passed through to shareholders, although special reporting rules apply and the opportunity to fully claim a share of the S corporation’s losses may be limited.
Unlike a partnership, allocations to S corporation shareholders must be in proportion to their shareholdings.
Thus this form of organization may offer less attractive tax planning opportunities. A shareholder’s pro rata share of S corporation income and deductions is combined with income and losses from other sources and reported on the shareholder’s individual income tax return.
The total taxable income is taxed at individual income tax rates applicable to the shareholder’s tax bracket.
CREDITS: This is an excerpt from A Guide to Starting a Business in Minnesota, provided by the Minnesota Department of Employment and Economic Development, Small Business Assistance Office, Twenty-eighth Edition, January 2010, written by Charles A. Schaffer, Madeline Harris, and Mark Simmer. Copies are available without charge from the Minnesota Department of Employment and Economic Development, Small Business Assistance Office.
This is also part of a series of articles on How to Pick the Right Business Entity Type. These articles help you select the right business type for your circumstances.