By Doug Bend
When deciding how to incorporate a business entity, it helps to know how each entity is taxed at the state and federal level. Business structure, liability, management and tax considerations are all factors in determining the best entity for the business, however, because there are many entities that provide liability protection it’s important to carefully consider the annual taxes your startup may face.
For tax purposes, a business entity is treated as one of the following:
- Disregarded entity
Using broad strokes (only an overview), this post discusses the tax implications of each entity at the state and federal level. This information is pivotal when structuring a start-up enterprise and will be critical moving forward after incorporation because the tax rules that apply to each entity are quite different.
A sole proprietorship is the simplest and most common form of starting a new business. In this type of business entity the owner and the business are one. There is no separate legal entity. For tax purposes, a sole proprietorship will include all sources of income when determining estimated tax payments.
A single member LLC (i.e. one owner) is treated as a “disregarded entity” and a multiple member LLC is treated as a partnership for tax purposes unless the LLC, whether single or multi-member, elects C-corp or S-corp tax status (more on this below).
A single-member LLC owns the assets of the entity for tax purposes and is also subject to the liabilities. Therefore, a single-member LLC, which is treated as a disregarded entity, does not file a US federal income tax return. Instead, the sole member of the LLC reports the LLC’s income and expenses directly on its own income tax return. In other words, a disregarded entity is essentially treated like a sole proprietorship, branch, or division of the owner.
In a single member LLC or a sole proprietorship the activities of the entity will generally be reflected on Form 1040 Schedule C for sole proprietorships, Form 1040 Schedule E, and Form 1040 Schedule F for LLCs.
Even though LLCs are recognized as a type of business entity under state corporate law, LLCs do not have their own US federal income tax regime. For tax purposes, an LLC with multiple partners is classified as a C-corp, S-corp or a partnership. An LLC taxed as a partnership allows the LLC members (the “partners”) to have the profits and losses allocated directly to them without the entity level taxation that comes with a C-Corp. This allows the profits and losses to “pass through” directly to the owners.
One important note to consider, when a multi-member LLC is formed the default is to be taxed as a partnership, however, an LLC can elect to be taxed as an S-Corporation, or even a C-Corporation (rare) if desired.
LLCs that are subject to partnership tax rules are not responsible for actually paying the tax on business earnings, instead, LLCs prepare an annual partnership tax return on IRS form 1065. This report is for information purposes only, as each owner is responsible for paying its taxes after the LLC prepares each member a K-1, which documents the profits and losses attributed to each owner.
An S-corporation is also a pass-through entity for tax purposes; therefore, it generally does not have to pay the entity level tax that C-corporations must pay (more on this to follow). Instead, the S-corp’s profits and losses pass through to its stockholders who include their respective share of those items on their income tax return.
Like standard partnership taxation, an S-corp is a pass-through entity. However, unlike standard partnership taxation an S-Corp has limitations around making S-Corp election. Under federal law, in order to qualify to by an S corporation the corporation must be (1) domestic, (2) have only allowable shareholders (ie. Individuals and certain trusts and estates), (3) have no more than 100 shareholders, (4) have only one class of stock, and (5) Not be an ineligible corporation.
Similar to an LLC, the S-Corporation does not pay income tax, but it is still required to file Form 1120S, which like the LLC taxed as a partnership is for information purposes only. Just like the LLC, the S-Corporation prepares a K-1 for each of it’s shareholders and it is the shareholders responsibility to report their respective profits and losses.
Having touched on both standard partnership taxation, and S-Corp taxation it’s worthwhile pointing out some key differences:
- All partnership income is generally considered self-employment income to the owners while an S-Corporation, generally only the compensation (such as the salary, and not the distributions) is subject to employment tax
- An S-Corporation must allocate profits according to share ownership, while an entity taxed as a partnership can generally divide profits in any way it chooses. For example, a shareholder in an S-Corporation who owns 10% of the stock, must receive 10% of the profits. This is not necessarily true in an LLC taxed as a partnership.
- Finally, entities taxed as a partnership do not qualify for certain statutory benefits which are available to C and S-Corporations. For example, a partnership cannot offer incentive stock options to employees, but they can offer a profit interest (i.e. share of profits, but not ownership) to achieve a similar tax result of a stock option.
C Corporations are separate entities for both state law and tax purposes. C-Corporations are taxed annually on their earnings, and the shareholders are taxed on these earnings when distributed as dividends (this is considered the dreaded “double taxation”). Once all of the corporation’s deductions and credits have been claimed, the remaining income is normally taxed at using the corporate income tax rates. Unlike individual tax rates, the corporate tax rate is not adjusted every year to account for inflation.
Unlike a disregarded entity, a partnership or an S-Corporation a C-Corporation pays its own tax as if it was an individual tax payer. A C-Corporation reports its income and claims its deductions on Form 1120, and the shareholders report any distributions provided to them on their individual tax return.
CA STATE TAXATION
As a sole proprietor, you will report all of your state and federal tax on your Schedule C.
All California LLCs not classified as a Corporation for tax purposes must pay the annual minimum franchise tax of $800, and an LLC fee (more on this below) payable each year to the Franchise Tax Board. The LLC fee is $900 if the LLC makes between $250,000 and 499,999, it goes to $2,500 if the LLC makes between $500,000 and $999,999, followed by $6,000 if it makes between $1,000,000 and $4,999,999 (and on from there).
A California S Corporation must pay the $800 minimum franchise tax as well as 1.5% of net income earned (take note that the LLC fee is based on gross receipts, while an S-Corporation is based on net income).
Finally, a California C Corporation must pay the annual minimum franchise tax of $800 as well as 8.84% of it’s net income.
When structuring an entity it is very important to work with an accountant and lawyer who can help you understand anticipated taxes. We routinely strategize during the formation stage, and we’d be happy to talk more about your upcoming legal needs at 415 633 6841 or at firstname.lastname@example.org.
This article was co-authored by Alex King and Rishi Gupta.
Disclaimer: This article discusses general legal issues, but it does not constitute legal advice. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.