Source: BizActions, Thomson Reuters
Background on Business Taxes and Owner Liability
The federal income tax treatment of a domestic business operation — one that’s domiciled in the United States — depends on how it’s set up. A business’s “choice of entity” has broad implications, including:
- Whether there’s an entity-level federal income tax,
- How much flexibility (if any) the entity has to allocate its taxable income among its owners,
- Whether individual owners are subject to the self-employment tax, and
- Whether the owners are liable for the entity’s debts and the entity’s access to capital.
When deciding how to set up a business, you have five basic options:
- Sole proprietorship. This is the most basic way to operate a business. For tax and legal purposes, a sole proprietorship is one and the same as its owner. So, a sole proprietorship’s tax results are reported on the owner’s personal return. A major downside with operating a sole proprietorship is that the owner’s personal assets are generally exposed without limitation to any liabilities related to the business. Sole proprietors also owe self-employment tax on net income from a non-rental business.
- C corporation. Businesses that incorporate are treated as separate legal and taxable entities apart from their owners. So, a C corporation owes corporate-level federal income tax on its taxable income (and possibly state income tax, too). If after-tax amounts are distributed to shareholders, the distributions may constitute dividends that are taxed again at the shareholder level, resulting in double taxation.
A major advantage of C corporation status is that the shareholders’ personal assets are generally protected from liabilities related to the corporation’s activities. In addition, C corporations face no tax-law restrictions on the type and number of shareholders it can have, the citizenship of its shareholders or the classes of stock it can issue.
- S corporation. This refers to a closely held corporation that elects to be treated as a pass-through entity for federal income tax purposes. While an S corporation is still a separate taxable entity from its owners and must file a corporate return (on Form 1120-S), pass-through status means the S corporation’s income, gains, losses, deductions and credits are passed through to its shareholders and reported on their returns. In general, there is no entity-level federal income tax on an S corporation’s earnings.
Several requirements must be met to qualify for S corporation status: The corporation must be a U.S. entity, it can have only one class of stock, and there are limitations on the type and number of shareholders it can have. As with a C corporation, the personal assets of an S corporation’s shareholders are generally protected from liabilities related to the S corporation’s activities.
- Partnership. This is a joint venture between at least two partners. Partnerships enjoy the benefits of pass-through tax status, including substantial flexibility to arrange transactions to reduce taxes. A partnership’s income, gains, losses, deductions and credits are passed through to its partners and reported on their returns. However, a partnership can (within limits) make disproportionate allocations of tax items (so-called special allocations).
For example, a 25% partner can be allocated 50% of partnership tax losses during the start-up period when losses are expected and then 50% of partnership income when the partnership goes into the black. After making up for the earlier special allocation of losses, the partner’s share of income can go back to 25%.
There’s no partnership-level income tax. In addition, there aren’t any tax-law restrictions on who can be a partner. In many cases, partnerships and partners can find ways to swap cash and other assets back and forth without triggering taxable gains or other adverse tax consequences.
The extent of a partner’s liability for debts of the business, if any, depends on the type and structure of the partnership. With a general partnership, all partners are exposed to partnership liabilities without limitation. But with a limited partnership, limited partners aren’t exposed to partnership liabilities (unless they guarantee them). General partners are exposed without limitation to partnership liabilities unless another partner guarantees them.
- Limited liability company (LLC). Single-member LLCs (SMLLCs) have only one member (owner) and are generally disregarded for federal income tax purposes. The tax items of a disregarded SMLLC owned by an individual taxpayer are reported on the owner’s personal return (same as with a sole proprietorship). The tax items of a disregarded SMLLC owned by a corporation are reported on the corporation’s return (same as with an unincorporated branch or division).
Multimember LLCs have more than one member (owner) and are generally treated as partnerships for federal income tax purposes. As such, they have the same tax advantages as partnerships.
LLC members (owners) generally aren’t personally liable for the LLC’s debts, unless they guarantee them.
Important note: LLCs can elect to be treated as corporations for federal income tax purposes, but that’s rarely done unless it’s followed by an election to be treated as an S corporation.
Here’s a summary of the returns filed for each of the five types of business entities over the last few decades:
|Year||Sole proprietorships*||C corporations||S corporations||Partnerships*|
|1978||8.9 million||1.9 million||479,000||1.2 million|
|1983||10.7 million||2.4 million||648,000||1.5 million|
|1988||13.7 million||2.3 million||1.3 million||1.6 million|
|1993||15.8 million||2.1 million||1.9 million||1.5 million|
|1998||17.4 million||2.3 million||2.6 million||1.9 million|
|2003||19.7 million||2.1 million||3.3 million||2.4 million|
|2008||22.6 million||1.8 million||4.0 million||3.1 million|
|2013||24 million||1.7 million||4.3 million||3.5 million|
* The statistics for sole proprietorships include SMLLCs taxed as sole proprietorships but exclude farms. The statistics for partnerships include LLCs taxed as partnerships.
The following trends have been observed:
- The number of businesses operating as sole proprietorships (or as SMLLCs treated as sole proprietorships for tax purposes) has increased by 270% over the last 35 years.
- The number of businesses operating as C corporations has actually declined over the last 35 years. This is a reaction to the 35% federal income tax rate that profitable C corporations have to pay and the dreaded double taxation threat that they face.
- The number of businesses operating as S corporations has increased by almost 900% over the last 35 years. This may be because S corporations have received more favorable treatment than C corporations under the Internal Revenue Code.
- The number of businesses operating as partnerships and as LLCs taxed as partnerships has almost tripled over the last 35 years. This reflects the fact that partnerships get favorable treatment under the Internal Revenue Code.
Corporate receipts over the 35-year period dropped from 15% to 10.6%, which is nearly a 30% drop. The drop is even more dramatic looking back to 1952, when the corporate income tax generated 32.1% of federal income tax revenue.
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