There is a common misunderstanding between types of business structures and how they are taxed. Some business owners cannot even tell the difference between an S Corporation and an LLC. You will hear a person saying that he owns an LLC, but is taxed as an S Corp. What is happening here is that the business owner is confusing his tax status with his business entity structure.
Starting us off is the simplest form of business structure – sole proprietorship. You and your business are one and the same thing, so the business itself is not taxed separately. For tax purposes you are required to report income, expenses, gain and/or losses using Schedule C on the standard IRS Form 1040. The “bottom-line amount” from Schedule C then transfers to your personal tax return. In addition, you are required to withhold and pay all income taxes, including estimated and self-employment taxes. For more detailed information about how sole proprietorship is taxed please visit IRS.gov.
Partnerships operate more or less in the same manner as sole proprietorships with the main difference being is that they are formed by two or more individuals. As far as taxes is concerned, Partnerships are required to file an annual information return and the business itself does not pay income tax. Instead, through the issuance of K-1 forms, the business partners share losses and profits at their pro rata share they each have in the business and this ends up flowing on to their personal tax returns. A complete guide to partnership taxes and forms are available at IRS.gov.
Limited Liability Company
In case of an LLC, there are 4 taxation methods to choose from: partnership, disregarded entity, C Corporation or S Corporation. On the other hand, a corporation can only be taxed as an S Corp or as a C Corp.
1. Disregarded Entity
An LLC will be taxed as a disregarded entity if it is owned by one person. The business is an LLC for legal reasons, but not so different than a sole proprietorship when it comes to taxation. The IRS thus disregards the LLC for tax purposes and thus losses and income flows to the owner’s personal Schedule C.
An LLC can also be taxed as a partnership when two or more individuals own the company. The business itself does not pay income tax. Business partners share income, losses and profits and as such partners are required to include their respective shares of the partnerships losses or gains on their personal tax returns. This arrangement helps to avoid double taxation.
3. S Corporation
An LLC can also be taxed as an S Corp. An S Corporation is created through an IRS tax election. This business structure can help avoid double taxation (One to the shareholders and again to the corporation). Your company must file for the Form 2553 to elect ‘S’ state anytime before the tax year or within 2 months and 15 days after the beginning of the tax year. Here’s more information about filing requirements for S Corps.
4. C Corporation
C Corporation is your regular corporation and unlike partnerships and sole proprietorship, corporations pay income tax on their profits. C Corporations are in some cases taxed twice (first when the company makes profit and again when dividends are paid to shareholders). Corporations use IRS Form 1120-A or 1120 to report revenue to the federal government. Employees who are also shareholders pay income taxes on their wages. For small businesses, corporations are rarely ever advantageous. Learn more about corporation taxation on IRS.gov.