Companies in the United States are taxable entities. How they are taxed depends on the designated “tax status”. This “tax status” occurs at the federal-level with the IRS, and the states adopt this status when dealing with corporate income tax.
Corporations can be taxed in one of two ways: S-Corporation and C-Corporation.
LLC’s can be taxed in one of four (4) ways: Disregarded, Partnership, S-Corporation and C-Corporation.
The S-Corporation and S-Corporation tax status is roughly the same, regardless of whether we’re talking about a LLC or Corporation, although there are some arcane differenced beyond the scope of this knowledge base article.
These various tax status differ in many different ways, including but not limited to:
- Who can own the company
- How profits and losses are allocated and distributed between the owners
- How (and how much) taxes are paid
- How profits and losses are recognized
There is no one “best tax status.” Each has its pros and cons, depending on circumstances. For example, a S-Corporation is generally favored because it can help save on self-employment taxes (up to 15.2% for 2019 TY), but that only kicks in after working owners are paid a “reasonable salary”, and the S-Corporation has some limitations on who can own the S-Corporation. Worse, if you violate the IRS requirements for maintaining S-Corporation status, you will lose the status. What happens then? The IRS assumes you’re a C-Corporation, and will go back years to recompute your tax basis, often costing tens-of-thousands in penalties, interest and back taxes.
So, which tax status is best for you? An accountant or CPA can best answer that question. We have put the following table together for you, to help guide you. Mouseover the footnotes, to learn more about a particular issue.
| Disregarded | Partnership | S-Corp | C-Corp | Liability Protection for Owners |
|---|---|---|---|---|
| Can own property | ||||
| Needs a separate tax return (1) | ||||
| Considered a “Pass-Through Entity” (1) | ||||
| Can be owned by individuals | ||||
| Can be owned by other entities | (2) | |||
| Can be owned by non-citizens | (2) | |||
| Restrictions on who can own the entity | (3) | (2) | ||
| Can have more than one owner | (3) | |||
| Owners have multiple types of ownership interests/classes of stock | ||||
| Owners can be employees of the business (5) | ||||
| Separately pays corporate taxes | ||||
| Owners customize how to allocate profits and losses (4) | N/A | |||
| Owners can save up to 15.2% by not paying self-employement taxes (6) | ||||
| Owners take “draws” from business earnings | ||||
| Owners take “distributions” from business earnings | ||||
| Owners take “dividends” from business earnings | ||||
| Subjects the owners to “double-taxation” (7) |
The Footnotes
( 1 ) A separate tax return is required at the Federal level and those states that tax companies, although pass-through entities means the profits and losses are reported at the owner level and even so, a partnership return must be filed, even though taxes are not technically paid at the company level for pass-through entities.Back to top
( 2 ) S-Corps cannot be owned by non-resident aliens and cannot have more than 100 shareholders. Can only be owned by certain natural persons, trusts, and disregarded entities.
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( 3 ) Disregarded entities can only have one owner, although if it has two owners that are married to one another in a community property state, then it is considered as “one owner” by the IRS.
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( 4 ) Profits and losses can be allocated and distributed at percentage levels that are different from ownership percentages. Partnerships are the only tax type that permits this. All other tax types require allocations and distributions of profits and losses to be exactly the same as the ownership levels.
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( 5 ) This doesn’t mean owners cannot work for companies taxed as partnerships, it just refers to how the owners are classified for tax purposes.
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( 6 ) It’s important to consult with a tax advisor. The savings on self-employment taxes can be substantial, but it does depend on how owners are paid and the income levels of the company.
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( 7 ) The company is taxed on its profits. Then, it distributes those profits to its owners via dividends, and the dividend income is taxed on an individual basis on the owners personal income taxes.
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Want More Information?
Read our article entitled, Do I have to file income taxes if I have a pass-through entity? We also have additional knowledge base articles regarding taxes.
