Tax Treatments for Small Business
Guide to Tax Treatments for Small Business in the U.S.
This page is part of our general Guide to Business Taxes.
There are four tax treatments that small businesses should be familiar with:
- Sole Proprietorship
- General Partnership
- C corporation
- S corporation
For the legal structures of sole proprietorships and general partnerships, the tax treatments are straightforward. A sole proprietorship can only be taxed as a sole proprietorship, and a general partnership is taxed as a general partnership.
Where things get complicated (in a good way) is that with certain legal structures, you can choose among various tax treatments in order to pay the lowest amount in taxes. This is called a “check the box” election. A corporation can be taxed as a C corporation or as an S corporation. An LLC can be taxed as a sole proprietorship (if one owner), a general partnership (if more than one owner), or as an S corporation or C corporation (regardless of how many owners). Note that an LLC is only a legal structure, never a tax treatment.
What does it mean to be taxed as a sole proprietorship?
Being taxed as a sole proprietorship is very simple. There is no tax at the entity level (since there is no entity). You, the business owner, are taxed on the profits from your business (income minus expenses) through your personal income taxes.
What does it mean to be taxed as a general partnership?
Partnerships are taxed by pass-through taxation. Pass-through tax treatment simply means the business profit is not taxed at the entity level; instead, it passes through the business, on to the business owners. The business owners are taxed based on their individual share of the profits, which is usually based on percentage ownership of the business.
As an example, say Maria and Jo are partners in MarJo, and Maria owns 60% of the business, while Jo owns 40%. If MarJo brings in profits of 100K, MarJo does not pay taxes on this. Instead, Maria would pay taxes on her 60K of income, and Jo would pay taxes on her 40K income.
What does it mean to be taxed as a C corporation?
Very few small businesses will want to use C corporation taxation. Here’s why. As a C corp, the corporation itself is taxed on its profits. When you move the income of the corporation to yourself as an owner of the corporation (called taking an owner’s draw or paying the owners dividends), this same income is taxed again on your personal income taxes! This situation is known, appropriately, as double taxation, and you will almost certainly want to avoid it by choosing another tax treatment.
That said, there is a way around the double taxation of a C corp. If you pay all the corporate earnings out to yourself and the other owners as salary, then there would be no corporate profit (since salary is a business expense), and thus no tax at the corporate level. You would just be subject to personal income taxes on that salary as if you were an employee. While this arrangement may be beneficial in certain circumstances, it’s much simpler and usually more cost-effective to be taxed as an S corporation.
What does it mean to be taxed as a S corporation?
The S Corp is a special kind of magic. Like a partnership, an S Corp has pass-through taxation. So, it avoids the double taxation of a C corporation. But it gets better. In a partnership, the owner’s draws are considered self-employment income, which, as you know, is subject to self-employment tax. In contrast, as a corporation, when you take an owner’s draw, it is not considered self-employment income, it’s considered dividends, just like when you own stock in the stock market. Since you don’t pay self-employment tax on dividends, you save over 15% on this money, which can add up to thousands of dollars!
While you would naturally want to pay out everything as dividends, it doesn’t quite work that way. The IRS requires you to pay yourself a “reasonable” salary before paying dividends. The definition of reasonable salary is one of those gray areas, but it’s generally based on an average salary for your specific profession or industry.
Here’s an example of how it can work. Let’s say you earn $80,000 net income from your business. Without an S Corp, you could end up paying around 35% tax on that (assuming 20% income tax + 15% self-employment tax), or $28,000. Now, with an S Corp: Perhaps a reasonable salary is $50,000, so the other $30,000 would be dividends. The $50K may be taxed at around 35% ($17.5K); while the $30K would just be taxed at the income tax rate, with NO self-employment tax, ($30K x .2 = $6K); for a total of $23.5K. You just saved $4,500 ($28K-$23.5K)! Go buy yourself something nice. Actually, you should invest that back into the business.
LLC (NOT a tax treatment)
Note that LLC is NOT a type of tax treatment. An LLC must choose to be taxed as follows: an LLC with a single owner can be treated as a sole proprietorship, S corporation, or C corporation; and if there are multiple owners, it can be treated as a partnership, S corporation, or C corporation.
If it chooses nothing, then by default, the LLC is treated as a sole proprietorship (if one owner), or a partnership (if more than one owner). It drives me a bit nuts, but even some lawyers and CPAs talk about a business being “taxed as an LLC.” This is not the proper way to describe it, and it just confuses people. When you read and hear this, keep in mind that it generally means the LLC’s default tax treatment as either sole proprietorship or partnership.
An LLC taxed as a sole proprietorship is usually considered a disregarded entity. This may sound problematic, or like you are being tossed aside like some garbage, but that’s not necessarily the case at all. It simply means that the IRS disregards or ignores the LLC and applies the same tax treatment as if you were a sole proprietorship. However, states generally do not disregard the LLC, and many states impose a minimum tax or fee on the LLC each year.
When an LLC is taxed as an S corp or C corp, the entity is often simply referred to as an S corp or C corp. This is more misleading terminology! A more accurate (yet admittedly cumbersome) way to describe it is an “LLC taxed as an S corp” or an “LLC taxed as a C corp.”
Which tax treatment will help save the most money on taxes?
Now that we have the basics covered, which tax treatment should you choose to get the most bang for your buck?
If you are just starting out and/or you aren’t making much profit yet, you would probably want to be taxed as a sole proprietorship (if it’s just you) or partnership (if you have co-owners).
What if you’re starting to bring in some real dough? Depending on what a reasonable salary is for your profession or industry, this is probably the threshold at which it may make sense to become an S corp. It could be $50K, $100K, etc. Basically, if you are doing better financially than your peers, congratulations. You may have reached “Level S” (I just made that up). But seriously, talk to a tax pro to see if you could save some serious cash.