It is important for individuals who want to start a new business to understand the taxation considerations related to a new company. This post will review the different organization options and the associated tax obligations and benefits of each entity type.
When considering what type of business entity to form, it is important to ask three questions:
- How many “owners” are in the business?
- Do the owner(s) wish to be personally liable for all financial and legal matters?
- Would the business prefer to file an entity-level tax return or report income as a pass-through to its owners?
A Closer Look at Each Entity Type
Sole Proprietorship
A sole proprietorship stands out from other entities because it is considered an unincorporated business that is owned by an individual who is personally liable for all financial and legal matters. Income taxes for this type of entity are assessed within the individual’s personal income tax return.
Key Components:
- Only one owner
- Owner has unlimited liability
- Income reported on individual’s tax return
Partnership
Partnerships refer to shared ownership among two or more people. Each partner is required to contribute to the trade or business in order to receive a portion of the profits and losses each year. There are three subsets of partnerships: general, limited, and limited liability partnerships. The main difference between these categories lies in how limited partnerships and limited liability partnerships offer the position of “limited partner(s)” who typically is not involved in management.
Key Components:
- At least two owners
- General partners have unlimited liability, while limited partners have limited liability, restricted to their investment in the limited partnership
- Pass-through income, which will be defined later
Corporation (or C Corporation)
For tax purposes, a corporation is treated as a separate entity that is distinct from its owners. Therefore, a disadvantage to incorporating as a C Corporation is the risk of double taxation – taxing on the same income twice! While the corporation is taxed on its income at the entity level, any dividends received by shareholders are also taxable at the individual level. Despite this potential downside, some benefits of a C Corporation include having no limits on stock classes and/or number of shareholders.
Key Components:
- Multiple shareholders or one shareholder, as there are no restrictions
- Limited liability
- Entity-level taxation
S Corporation
The S Corporation election allows for a business to receive the same limited liability shareholder benefits as a C Corporation, but the double taxation risk is eliminated because S Corporations are considered pass-through entities for tax purposes. However, with this benefit comes many limitations, including allowing only one class of stock, prohibiting partnerships, corporations, or nonresident aliens from being shareholders, and requiring allocation of profit based on shareholders’ ownership percentages.
Key Components:
- 100 shareholders or less and one class of stock
- Limited liability
- Pass-through taxation
Limited Liability Company (LLC)
Lastly, the LLC option offers similar benefits to S Corporations, but with fewer limitations regarding who can be involved in the business. A unique component of an LLC is that it can elect to be taxed as any of the previous three entities, including a sole proprietorship, partnership, or corporation (S or C) on Form 8832.
Key Components:
- Unlimited shareholders
- Limited liability
- Entity is not taxed, unless elected
The IRS website provides additional information about business structures, and the SBA’s helpful business entity chart shows a visual comparison between each entity type.
Business Taxation Run-Down
There are several different types of taxes business owners must pay, which are briefly reviewed below. (refer to the IRS business tax webpage for more details)
Income Tax
Paying taxes on income applies not only to individuals, but also to businesses. How this tax is paid and reported varies by entity type, as noted above. C Corporations are required to maintain accurate tax records and file income tax returns annually. On the other hand, S Corporations, Partnerships, and LLCs file an annual information return, which is passed through and reported on an individual basis.
State Tax
In addition to the federal income tax, corporations in 44 states must also pay taxes on business profits at the state level. Three states, Ohio, Nevada and Washington, look at gross receipts instead of income; and Texas assesses a franchise tax on every business, even if it is considered a pass-through entity. Two states, South Dakota and Wyoming, do not have corporate taxation at all. (visit the Tax Policy Center for more details on state-level taxation)
Estimated Tax
Not all businesses are required to make estimated tax payments at the entity level. These requirements only apply to those entities that pay an income tax (C corporations and sole proprietorships). Within these groups, only those businesses with tax circumstances that must be resolved to avoid penalties or fees must pay estimated taxes. However, individual business owners who must report pass-through income from partnerships, S corporations, and LLCs (when pass-through is elected) may also need to pay estimated taxes.
Employment Tax/Self-Employment Tax
For businesses with employees, the employer must uphold proper taxation standards, which generally includes the following taxes:
- Social Security and Medicare
- Federal income tax withholding
- Federal unemployment tax (FUTA)
All business entity types are responsible for properly withholding these taxes for their employees. An individual who works for him/herself is considered self-employed and must pay self-employment tax to maintain proper social security and Medicare withholdings.
Excise Tax
Excise taxes are imposed on certain goods, services, and activities. These taxes may be paid by importers, manufacturers, retailers, and consumers, and vary depending on the specific tax. Most types of excise tax liability are reported and paid quarterly on Form 720, however, some specific types of excise taxes require separate filings. (see the IRS excise tax webpage)
Final Notes
Having to file a business tax return and manage accurate bookkeeping can be stressful. If you need advice about starting a new business or assistance with the tax situation of your current company, please contact a GYF Tax Professional at 412-338-9300.
Lauren Dugan provided research and writing assistance for this post. She is a student at Robert Morris University, and will graduate with her BSBA and MBA degrees in 2025. Lauren is currently working as a summer intern with GYF’s Tax Services Group, helping to prepare individual and business tax returns.
