Entity Tax Type Comparisons

Business Entities and Taxes

The way in which the IRS taxes a business depends largely on its entity. In the U.S., there are five main business entities:

• Sole proprietor
• Partnership
• LLC
• C-corporation
• S-corporation

Sole proprietorships have pass-through taxes, which means the profits for the business are not taxed on their own; instead, they are taxed on the business owner's tax return. Partnerships also experience pass-through taxes, with each partner in charge of paying the taxes on his or her share of the profits.

Conversely, corporations must pay tax on their profits on separate tax returns. Owners, share-holders, and members must also pay income tax on their share of the profits, which is why corporations are often considered "double taxed." The money earned is taxed at the corporation level, and then the shareholders must also pay taxes on the funds.

Corporations can choose to become a pass-through entity by filing an election to be an S-corporation. LLCs have the choice to be a pass-through entity or be taxed as a corporation but are pass-through by default (an election would need to be filed to change to corporation taxation).

LLCs and S-corporations: What Is the Difference?

Most businesses looking for some level of liability protection for the owner's property will choose an LLC or corporation business structure rather than a sole proprietorship or a partnership. What distinguishes LLCs from S-corps? There are a few main features:

• S-corporations must pay applicable state corporate taxes and payroll taxes
• S-corporations are responsible for paying state unemployment and disability tax on the salary of the owner, as well as social security and Medicare taxes
• S-corporations might be subject to a minimum corporate tax at the state level
• LLCs are required to pay quarterly taxes, while S-corporations generally have taxes taken out as part of the owner's regular salary

For many one-person businesses, LLCs make more sense. Larger businesses might find benefits to the corporate structure, especially when taking advantage of the pass-through taxation of S-corps.

There is also a difference in how the government taxes the two entities, although both are pass-through entities. LLC members or owners pay business tax on the net profit of their share of the business.

It is a little different for S-corporations. Owners are paid a reasonable salary from the profits. Then, any remaining profits pass through to be taxed on their individual income tax return. So, if you are the sole owner and the company profited $100,000 and your reasonable salary was $40,000, you would pay personal income taxes on your salary of $40,000 and business taxes on the rest of the profits, which in this case is $60,000.

Taxation for Pass-Through Entities After the 2017 Tax Reform Bill

Under the new tax law, the corporate tax changes from a range of 15 percent to 39 percent to a flat 21 percent. Those who have business income from a pass-through entity, such as certain LLCs and S-corporations, face a different rate: the individual tax rate less a deduction of up to 20 percent of their business profits. For many, this still allows for a lower tax rate than corporations.

To calculate it, those who make less than the threshold amount ($157,500 for single filers and $315,000 for married), then you would take your qualified business income, or the net income from your business, and deduct 20 percent. For S-corporations, the 20 percent deduction only applies on the income after paying the salary to the owner. The deduction also takes into account the payroll of the business, and for S-corporations, this is limited to half of the payroll.

There are limits and restrictions to this deduction, especially those above the threshold. Those above will have to consider certain limitations and exceptions based on the industry and occupation, as well as the wage and capital limit. Professional services do not qualify for this pass-through deduction upon earning profits above the threshold.

It is best to consult a CPA to determine the exact impact on your business, especially if you make above the threshold. Some businesses might find it better to be taxed as a corporation, especially larger businesses with significant profits.