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In terms of the types of legal entities, you will typically come across the below five entities:
• Sole Proprietorship
• Partnership
• S Corporation
• C Corporation
• Limited Liability Company (LLC)
Let’s dive deeper into the above business structures now by taking a look at a few questions below:
Are all of the five legal structures considered by the Internal Revenue
Service (IRS) as taxpaying structures?
Out of the above five legal structures, the LLC is not considered by the Internal Revenue Service (IRS) as a taxpaying structure. Hence, an LLC will be taxed as either a sole proprietorship or a partnership or a S Corporation or a C Corporation. By default, an LLC with a single owner gets taxed like a sole proprietorship and an LLC with multiple owners gets taxed like a partnership. That said, an LLC with two or more owners may elect to get taxed as either a S Corporation or a C Corporation.
Why are sole proprietorships, partnerships and S Corporations considered
as pass-through entities but not C Corporations?
Profits/losses of sole proprietorships, partnerships and S Corporations flow through to the business and get taxed on the individual tax returns of the business owners. These business owners pay full tax on the income of their business each year. Thus, these business structures act as pass-through entities. In contrast to this, a C Corporation pays corporate income taxes at the business entity level and its owners (the shareholders) pay tax on the dividends they receive (when the C Corporation decides to distribute the after-tax income as dividends) or when they realize capital gains on selling the stock of the C Corporation. Notice that a C Corporation’s income gets double taxed.
Does my business need to file a business tax return at all?
Sole proprietorships get their business income computed on the owners personal Form 1040 (schedule C, E or F). Thus, sole proprietorships are not required to file any separate business tax return.
A partnership must file an informational tax form (Form 1065). It does not owe any tax on the tax return filed. Along with the return, a Schedule K-1 is also provided to the IRS. The same is provided to each partner as well so that they can take information from this schedule and add to their personal Form 1040 returns.
An S Corporation must file a Form 1120S. It does not owe any tax on the tax return filed. Along with the return, a Schedule K-1 is also provided to the IRS. The same is provided to each owner as well so that they can take information from this schedule and add to their personal Form 1040 returns. C Corporations file Form 1120.
Things get interesting for an LLC.
• A single-member LLC will file Schedule C, E or F with the owner’s personal Form 1040 because the IRS treats a single-member LLC as a sole proprietorship unless this LLC elects otherwise.
• A multi-member LLC can be taxed as either a partnership or an S Corporation or a C Corporation but the default tax status is that of a partnership unless the multi-member LLC elects to get taxed as a corporation. Thus, a multi-member LLC which has not elected otherwise will have to provide Form 1065 and Schedule K-1 to the IRS and will have to provide Schedule K-1 to each member of the LLC so that they can take information from this schedule and add the same to their personal Form 1040 returns.
• If a multi-member LLC elects to be taxed as an S Corporation, it first needs to submit Form 2553 to the IRS. It will then file a Form 1120S and a Schedule K-1. This schedule is provided to each member of the LLC so that they can take information from this schedule and add the same to their personal Form 1040 returns.
• If a multi-member LLC elects to be taxes as a C Corporation, it first needs to submit Form 8832 to the IRS. It will then file form 1120.
What about running payroll? How should salaries be paid?
If a sole proprietorship has no employees, there is no need to run payroll. The owner withdraws from the business as and when the need arises because the owner cannot pay wages to himself/herself.
In a partnership, the partners receive guaranteed payments and not wages. So, there is no need to run payroll unless there are non-partner employees.
S Corporations must mandatorily run a payroll even if the members of an S Corporation have not hired anyone else as an employee. C Corporations must also run a payroll.
What taxpayer identification number do the five legal structures use?
Sole proprietorships that hire employees (whether or not they hire contractors) or sole proprietorships that file excise or pension tax returns must mandatorily obtain employer identification number (EIN) and use the same as their taxpayer identification number. In contrast, sole proprietorships that have no employees (even though they may be hiring contractors) and do not file any excise or pension plan tax returns can either use the owner’s social insurance number (SIN) as taxpayer identification number or obtain an employer identification number (EIN) and use it as taxpayer identification number. In other words, despite having no employees, sole proprietorships have the choice of obtaining an EIN. The question is whether it is worth going through the hassle of obtaining an EIN just for the sake of using it as a taxpayer identification number when the sole proprietorship has no employees or is not filing any excise or pension plan tax returns. There are several other reasons why obtaining an EIN is helpful. Firstly, opening of a business bank account (to avoid commingling of business and non-business transactions) requires an EIN. Secondly, using EIN in place of SIN helps reduce any risk from identity theft. Thirdly, when the sole proprietorship is ready to hire an employee, it will have the EIN ready. Finally, since EIN can help establish a separate credit, a business can use this creditworthiness while seeking business loans.
Partnerships must obtain an EIN. Regardless of the number of partners, just one EIN is required. S Corporations and C Corporations must also have an EIN.
How does liability protection work?
Since a sole owner is not considered as being separate from the sole proprietorship, the owner’s personal assets have zero protection. One way to get around is to form the business as a single-member LLC (which by default is taxed as a sole proprietorship by the IRS).
In case of a partnership, the personal assets of the partners have zero protection unless it is either a limited partnership or formed as a multi-member LLC (which by default is taxed as a partnership by the IRS). S Corporations and C Corporations enjoy liability protection.