Business Entities: What are the Tax Differences?

By William Colangeli, CPA

When you decide you want to go into business, there are many important decisions that you must make that will affect your personal and business finances for years to come. One of these choices is deciding your business entity. A business entity is the form through which you conduct your business transactions.

There are several factors to consider when choosing your business entity, ranging from liability protection to tax implications. In this article, we will review the tax implications for the main entity types with regards to the net profit of the business, dividends and wages.

There are basically two business entity categories. One is the unincorporated business entity, which includes Sole Proprietors, Partnerships and Limited Liability Companies (LLC). The other category is the incorporated business entity, with its two tax related subsets, the C Corporation and the S Corporation. For each of these major business forms, we will review three general tax dimensions: Federal and State Income Taxes, Social Security Taxes and other Employment Taxes.

Unincorporated Businesses

In general, the owners of an unincorporated business report and pay income tax on 100% of the net profit of the business. The net profit is the amount left over after deducting expenses from the sales of the business. If it happens that the business has a loss, that loss may become an income tax deduction for the owners. The net profit or loss of an unincorporated business is generally reported on a Schedule C, Schedule E or Schedule F of the owner’s personal income tax return (Form 1040).

The active owner of an unincorporated business is also responsible for Social Security Taxes on their share of the net profit. Active owners are generally those that “work” in the business. There are no other employment taxes that must be paid by the owners of an unincorporated business.

Incorporated Business – C Corporation

Generally speaking, with a C Corporation, the owners do not pay income taxes on the net profit of the business. The C Corporation pays income taxes on the net profit. If the C Corporation pays the net profit to the owners, then that payment could be taxable to the owners. The C Corporation’s payment of net profit to the owners is considered a dividend and the owners generally pay income taxes on these dividends. If the owners of a C Corporation receive wages from the business, these wages will be treated as income to the owners and the owners will be subject to income taxes and social security taxes. The Corporation will pay social security taxes and other employment taxes on these wages.

However, there are scenarios where the above rules may not apply. For instance, in a case where a C corporation has a loss carryover from the previous year and the net profit of the current year is less then this loss carryover, then the business will not pay taxes for the current year. This is just one of many scenarios that could occur outside of the general rules just described.

Incorporated Business – S Corporation

Typically with an S Corporation there are two sources of income that could be subject to income taxes. These income sources are the net profit and the wages that the owners take from the corporation. The owners of an S Corporation do pay income tax on the net profit of the corporation. However, they do not pay social security or other employment taxes on the net profit. If the owners take profit out of the corporation via a dividend, they do not pay income or any other taxes on that dividend.

If the owners should take a wage from the business, they will need to pay the appropriate income and social security taxes. In addition, the S Corporation will pay social security and other employment taxes on that salary as well. If there is a net loss of the business, it may or may not be an income tax deduction for the owners.

Which Entity Saves Money?

Generally speaking, when trying to reduce overall income taxes of the owners and the business, the C Corporation may offer the most opportunity. The opportunity may be maximized when the C Corporation is not paying dividends. S Corporations offer an opportunity to lower income taxes when dividend payments are contemplated. With regards to other employment taxes, the unincorporated business probably provides the most opportunity.

This analysis is only considering the tax aspect of incorporating your business or operating as an unincorporated business. When you are choosing a business entity, there are several other factors, in addition to the tax area, that you will want to consider. Some of these other considerations include: liability, insurance, ownership and retirement plans. When making an important decision such as this one, it is always wise a idea to consult a qualified professional, who will be able to ask the right questions and assist you in determining the most beneficial business entity for you.

William Colangeli, CPA is a partner at O’Malley & Colangeli, CPAs, PC located in Bedford, MA, a public accounting firm providing bookkeeping, financial accounting, tax and management advisory services to small and medium sized businesses. For more information on business entities, please call Bill at 781-275-8897 or e-mail him at wcolangeli@omalleyandcolangeli.com. www.omalleyandcolangeli.com