Taxation Of Business Entities

Taxation Of Business Entities

The human mind has devised a wide variety of business entities—that is, of forms of doing business. The mind of the IRS has kept up, devising tax rules for these entities. Often, however, these rules involve taxing the owner of the entity, and not the entity itself.

There are basically two federal tax systems for businesses:

Taxation of both the entity itself (on the income it earns) and the owners (on dividends or other profit participation the owners receive from the business). This system applies to the business corporation—called the "C corporation" (C corp.) for reasons we’ll see shortly—and the system of taxing first the corporation and then its owners is called the "corporate double tax".
"Pass-through" taxation. The entity (called a "flow-through" entity) is not taxed but its owners are each taxed (more or less) on their proportionate shares of the entity’s income. The leading forms of pass through entity (further explained below) are:
Partnerships, of various types.
"S corporations" (S corps), as distinguished from C corps.
Limited liability companies (LLCs).

A sole proprietorship—such as John Doe Plumbing or Marcus Welby, M.D.—is also considered a pass through entity even though no "organization" may be involved.

The first major consideration—in this case, a tax consideration—in choosing the form of doing business is whether to choose an entity (such as a C corp.) that has two levels of tax on income or a pass through entity that has only one level (directly on the owners).

TIP: Co-owners and investors in pass through entities may need to have their operating agreements require a certain level of cash distributions in profit years, so they will have funds from which to pay taxes.

Losses are directly deductible by pass through owners while C corp. losses are deducted only against profits (past or future) and don’t pass through to owners.

TIP: Business and tax planners therefore typically advise new businesses—those expected to have startup losses—to begin as pass through entities, so the owners can deduct losses currently against their other income, from investments or another business.

The major business consideration (as opposed to tax consideration) in choosing the form of business is limitation of liability, that is, to protect your assets from the claims of business creditors. State law grants limitation of liability to corporations (C and S corps), LLCs, and partners in certain forms of partnership. Liability for corporations and LLCs is generally limited to your actual or promised investment in the business.

Taxation of business entities is very complex. Tax aspects of the business income and expenses are very different for different business entities. Please select the type of your business entity, and visit the appropriate page to find more information.

Corporations | Limited Liability Companies

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