Tax implications of different types of business entities

CMC Network Tax Strategy

As mentioned in the blog post regarding business legal entities, there are tax implications to think about when you are choosing the type of legal entity that represents the best fit for your business goals.  This article will discuss the taxability of a sole proprietor, a partnership, a corporation and a limited liability company (LLC).  

Sole proprietor 


Their net income is reported on their individual income tax returns utilizing Schedule C.  A sole proprietor does not pay themselves wages through a W-2, but draws from the business profits as wages. 

The taxable income (including the draw) is then subject to the ordinary income tax rate (just like all the individual’s other taxable income), plus self-employment tax. Self-employment tax is made up of the social security tax (both the employer and the employee portion) and the Medicare tax (both the employer and the employee portion).

These tax rates sum up to a total of 15.3% on the first $142,800 for 2021 and 2.9% on the amount over $142,800.  


Partnership


A partnership, which must have more than one partner, reports its net income on a partnership return (Form 1065). 

The net income is then allocated to each partner — typically based on ownership percentage — and reported to each partner on a K-1.  The partners then utilize the K-1 to report their portion of their taxable income on their individual income tax returns.

The taxable income, like with a sole proprietorship, is taxed at the individual’s ordinary income tax rate plus self-employment tax. 

Also similar to a sole proprietor, a partner is not paid a wage through a W-2, but takes their wage through a guaranteed payment, which is then reported on the K-1 in addition to the net income allocated to that partner.  


Corporation

A “C” corporation reports its net income on a corporation return (Form 1120). The net income is subject to a flat rate of 21% at the federal level, 6.5% at the state level (New York, specifically) and 8.85% at the city level (New York City, in this case). 

As a corporation, the owners are eligible to pay themselves a wage through a W-2. What separates a “C” corporation from a partnership is that when a shareholder takes a dividend from the “C” corporation, they will pay a tax again when the dividend is reported on their individual income tax returns: double taxation. 

A “C” corporation can make an election (with certain exceptions) to be treated as an “S” corporation.  

An “S” corporation reports its net income on an “S” corporation return (Form 1120S).

The net income is allocated to each shareholder (can be only one) based on their ownership percentage and reported to each shareholder on a K-1. The shareholder then utilizes the K-1 to report that portion of the taxable income on their individual income tax returns.

The taxable income, like with the partnership and sole proprietor, is taxed at the individual’s ordinary income tax rate.

Unlike a partnership and sole proprietor, an “S” corporation’s taxable income is not subject to self-employment tax. This results in only one level of taxation (individual level) and avoids the double taxation a “C” corporation is subject to.  

LLC


The final type of entity is the LLC, which has the most flexibility.

An LLC is not recognized as its own type of entity for income tax reporting purposes. Therefore, an LLC can elect to be treated as any of the above types of entities, depending on the number of members.

A sole member LLC can be treated as a sole proprietor, “C” corporation or an elected “S” corporation. A multi-member LLC can be treated as a partnership, “C” corporation or an elected “S” corporation.  

The bottom line is that it is important to discuss both the legal and tax implications of the entity that you choose with both an accountant and an attorney. 


Author

  • Adriane Shaffer is a licensed CPA with over 20 years of experience. She specializes in working with small to mid-size companies in the New York City and New Jersey regions. Her industries of expertise include construction, real estate, medical practices and wholesale distribution. She got her bachelor’s degree in accounting from Rowan University.

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