By: Nichollas Dawson

Often in the early stages of a business, the most important decision a founder can make involves how their startup will be taxed. [1] The tax treatment of a newly formed business can have dire implications for young entrepreneurs that may be relying on the meager income from their business to survive. That is why, in order to create a sustainable venture, entrepreneurs should consider how their own finances will be affected by the entity that they choose.

 

Sole Proprietors and General Partnerships

 

If the entrepreneur(s) have not created an entity they are treated as either a sole proprietor or a general partnership. Both of these forms have what is known as pass-through status. This means that the business itself does not pay taxes. Instead, the profits and losses of the business “pass through” to the individual (in the case of a sole proprietor) or individuals (in the case of a general partnership) that own the business.

 

For both a general partnership and a sole proprietor the owners are required to pay taxes on their share of the business’ profits. For a sole proprietor this means that the owner must declare all of the profits of the business. For a general partnership, the partners must pay taxes on their respective share of the profits. These taxes must be paid regardless of whether or not the individuals actually received the profits.[2]

 

For example, if a two-member general partnership (where each partner is allocated 50%) makes $100, gives each partner $25 as income and then retains the remaining $50 in the company account, the partners are taxed as though they had received the full $50 to which they were entitled not the $25 that they actually received.

 

Forms to File

 

As stated above both the sole proprietor and the general partnership do not pay taxes on the profits of the company. However, there are still forms that will need to be filed, whether by the individual or the entity regarding profits. For a sole proprietor, in addition to the individual’s typical 1040, they will also be required to append Schedule C to declare the income or losses of the business. For a general partnership the actual partnership is required to file a Form 1065. The partnership must also file a Schedule K-1 for each partner and provide a copy of that document to the respective partner. Although they must be filed with the IRS, no actual taxes are paid from these forms. Instead the IRS uses them to ensure that the partners are reporting their income appropriately. The partners themselves file their normal 1040 and attach Schedule E to report income from the partnership. Finally, in accord with the self-employment section below, sole proprietors and general partnership members must file Schedule SE with their Form 1040 in order to declare their self-employment tax amounts.[3]

 

Self-Employment Tax

 

In addition to income taxes, active sole proprietors and members of a general partnership are subject to the self-employment tax. The self-employment tax is levied as a contribution to Medicare and Social Security. For wage earning employees this tax is collected through the employment or payroll tax. Under a payroll tax an employer will withhold a certain amount of an employee’s paycheck and then will contribute a matching amount to cover the amount the employee owes in payroll tax. Since entrepreneurs are generally not considered employees of the business instead of a payroll tax they must pay a “self-employment” tax.[4]

 

The self-employment tax is 15.3% and is paid on top of the entrepreneur’s income taxes. 12.4% (of the 15.3%) goes to Social Security and the remaining 2.9% funds Medicare. However, 50% of the 15.3% (approximately 7.6%) is deductible as the amount that an employer would have paid in a traditional employer-employee relationship.[5]

 

The self-employment tax is bifurcated between the programs that it funds and both portions are subject to different thresholds. The Social Security portion of the tax only applies to an individual’s first $128,400, with any additional income being exempt from the 12.4% tax. For the Medicare portion however, the threshold applies differently. For the first $200,000 (if filing single, $250,000 if married and filing a joint return) of income the taxpayer will pay 2.9%. For any amount over that threshold there is a 0.9% surtax bringing the total tax paid on the over threshold amounts to 3.8%.[6]

 

As of the 2018 Tax Cuts and Jobs Act, sole proprietors and members of a general partnership can also take advantage of a 20% pass-through tax deduction. Section 199A allows a deduction of up to 20% of qualified business income (QBI) for pass-through entities but is limited to 20% of an individual’s total taxable income (income after deductions). QBI is the net income (profit) of the company excluding any investment or interest income, income generated outside the US, or any guaranteed payments to a partner. So, Section 199A allows an entrepreneur to take 20% of their QBI (or their profits) and deduct that amount from their taxable income when preparing their income taxes. However, that amount (the 20% of QBI) cannot be greater than 20% of the entrepreneur’s taxable income.[7]

 

LLCs

 

An LLC is also a pass-through entity. This means that the LLC itself does not pay taxes. Instead, single-member LLCs are taxed as though they were a sole proprietorship (also referred to as a disregarded entity) and multi-member LLCs are taxed as general partnerships by default. This includes filing all of the same forms with the IRS. Also, so long as a member of the LLC is actively working in or managing the business they will be subject to the self-employment tax in the same way they would be if they were in a general partnership or sole proprietorship. Owners may also continue to avail themselves of the pass-through tax deduction.[8]

 

C-Corporations

 

The C-Corporation structure is markedly different from the other entities already discussed. First, it is treated as its own taxable unit. This means that the corporation itself must file taxes.[9] Second, individual members of the corporation do not need to pay taxes until they specifically receive something from the corporation.

 

Salaries

 

For founders, this means that they do not need to pay taxes on profits of the company until they are paid in the form of salaries or dividends. From a tax perspective, founders receiving a salary are treated as though they were ordinary employees. This means that the founder should include this income on their tax return. This also means that the corporation may deduct the cost of salaries on its own income tax return. Because the founders are treated as employees in this situation, they also are not subject to the self-employment tax. They do however have to have a certain portion of their salary withheld to contribute to the payroll tax. Likewise, the corporation must match that amount to cover the necessary contribution to Social Security and Medicare.[10]

 

Dividends

 

When a C Corporation distributes a dividend, founders must report and pay the appropriate taxes. However, corporations are not able to take a necessary and ordinary business deduction on this expense. This means that the money used for dividends is taxed twice. First, when the corporation earns the money at the corporate tax rate and then when it is received by the shareholder at the appropriate capital gains rate.[11]

 

S-Corporations

 

An S Corporation is not a separate entity. Rather, it is a regular corporation that has elected to be taxed as a pass-through entity under subchapter S of the Internal Revenue Code. This means that the S Corporation does not pay any taxes on profits and those profits are instead “passed through” to the shareholders. Shareholders must include the profits of the business on their personal tax returns. However, this also means that the S-Corporation shareholder may take advantage of the new pass-through deduction.[12]

 

Forms to File

 

Although an S-Corporation is not separately taxed, it must file a Form 1120S with the IRS as an annual tax return. The corporation must also complete a Schedule K-1 for each shareholder and provide a copy of that document to both the shareholder and the IRS.[13]

 

Salaries

 

If a shareholder of an S-corporation is actively working for the business they may be paid a salary or wages. This amount is not taxed beyond the amount already declared by the shareholder when the money was earned by the corporation. However, because the shareholder is receiving compensation for services they are also subject to the self-employment tax similar to a member of an LLC. Additionally, wages paid to s-corporation shareholders cannot be included in calculating the QBI that is passed through to shareholders.[14]

 

Non-Dividend Distributions

 

Since a dividend is technically a distribution after taxes, when an S-Corporation distributes money to shareholders it is not considered to be a dividend because the entity never paid a tax. It is instead referred to as a non-dividend distribution. These payments are not subject to self-employment tax and can result in substantial savings to shareholders. However, in order to grant non-dividend distributions, it is often required that the company pay ‘reasonable compensation’ to shareholders that provide ‘substantial contributions’ to the business. If the IRS determines that a distribution was paid in lieu of reasonable compensation they may re-characterize the payment as wages. The exact definitions of ‘reasonable compensation’ and ‘substantial contributions’ have yet to be fleshed out by the IRS or the courts, but are a source of increasing litigation.[15]

 

Conclusion

 

There is no straightforward answer when it comes to choosing the right entity for a budding entrepreneur. The answer is dependent on a number of factors, from the number of employees and founders, to the specific method for dispersal of funds. Founders should consider reaching out to a licensed tax professional to determine the best steps forward for their particular situation.

[1] This article deals solely with the federal treatment of tax on the income of a business. It does not discuss state or local taxes nor does it discuss the tax treatment of intra-business transactions (i.e. capital contributions by partners)

[2] https://www.nolo.com/legal-encyclopedia/how-partnerships-are-taxed-29710.html; https://www.nolo.com/legal-encyclopedia/how-sole-proprietors-are-taxed-30292.html

 

 

[3] https://www.irs.gov/forms-pubs/schedules-for-form-1040

[4] https://www.irs.gov/businesses/small-businesses-self-employed/understanding-employment-taxes

[5] https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes

[6] https://www.irs.gov/businesses/small-businesses-self-employed/self-employment-tax-social-security-and-medicare-taxes; https://www.irs.gov/businesses/small-businesses-self-employed/questions-and-answers-for-the-additional-medicare-tax

 

 

[7] https://www.nolo.com/legal-encyclopedia/the-new-pass-through-tax-deduction.html

[8] https://www.nolo.com/legal-encyclopedia/how-llcs-are-taxed-29675.html

[9] This article focuses primarily on the tax treatment of founders. The tax treatment of corporate profits is discussed in more detail in a different post.

[10] https://www.nolo.com/legal-encyclopedia/how-corporations-are-taxed-30157.html

 

[11] https://www.nolo.com/legal-encyclopedia/how-corporations-are-taxed-30157.html

[12] https://www.nolo.com/legal-encyclopedia/s-corporation-facts-30002.html

[13] https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

[14] https://www.thetaxadviser.com/issues/2011/aug/nitti-aug2011.html

[15]https://apps.americanbar.org/buslaw/committees/CL983500pub/newsletter/201207/cummings_s_corp_comp.pdf