When you start a business, one of your first major decisions is what sort of entity you want the business to be. Sole proprietorship? Limited liability company (LLC)? Corporation?
How you want the business to be taxed should be a major consideration in deciding your business structure.
Most small businesses—and quite a few larger ones—are set up as "pass-through" entities. In a pass-through entity, also knows as a "flow-through" entity, business income isn't taxed at the company level. Instead, that income "passes through" or "flows through" to the owners and is reported on their individual tax returns.
Pass-through entities avoid the double-taxation of business income that applies to C corporations (more on that below).
When it comes to tax status, the major business entities fall into one of two groups:
In other words, all business entities except C corporations are pass-through entities.
C corporation net income is taxed at the corporate level. (The C corporation is the only type of business that pays a company-level tax.) C corporation earnings are then taxed again when they're distributed to shareholders as dividends.
Having those two tax layers of tax is known as "double taxation"—the income is subject to the corporate income tax and the individual income tax.
With sole proprietorships, LLCs, partnerships, and S corporations, business income flows through to the business owners and is taxed only at the individual level.
Avoiding double taxation is a major reason for the explosion in popularity of LLCs in recent decades. LLCs afford limited liability protection to owners while being taxed at only the individual level. (More on LLCs below.)
The IRS treats sole-proprietorships as "disregarded entities," which means that the owner reports business income and expenses directly on Schedule C of their personal tax return. Schedule C serves as the profit and loss statement for the business's tax purposes.
Partnerships as business entities are not as popular as LLCs or corporations. But partnership taxation remains a cornerstone of business taxation because LLCs with more than one owner are taxed as partnerships. All partnerships are pass-through entities.
LLCs with only one owner ("single-member LLCs" or "SMLLCs") are sole-proprietorships for tax purposes, with income and expenses flowing through to Schedule C of the member's personal tax return. (LLCs owned by two spouses are considered SMLLCs.)
The IRS treats LLCs with more than one owner ("multi-member LLCs") as partnerships by default. As explained below, an LLC can elect to be taxed as an S corporation, but most multi-member LLCs are taxed as partnerships. For more information on LLC taxation, read about how LLC members are taxed.
S Corporations aren't actually a separate type of business entity. S Corporation is a special tax status that corporations and LLCs can elect.
A corporation that would be taxed as C corporation by default and subject to double-taxation can elect to be taxed as an S Corporation, which is a pass-through entity. LLCs can also elect to be taxed as S Corporations.
Why would an LLC, which is already a pass-through entity, elect S corporation status? As we'll explain below, S corporation status can result in savings on self-employment (Social Security and Medicare) taxes. (For more information on LLCs choosing S Corporation status, see Why You Might Choose S Corp Taxation for Your LLC.)
The pass-through income deduction, introduced in 2018 as part of the Tax Cuts and Jobs Act, allows business owners of pass-through entities to deduct up to 20% of "qualified business income" (QBI) on their personal tax return.
This deduction can result in huge tax savings, and offset self-employment tax (covered below), but it's subject to complicated restrictions having to do with personal income limitations and types of businesses. The deduction will last through 2025, unless Congress extends it. For more information on the QBI deduction, see The 20% Pass-Through Tax Deduction for Business Owners.
It's helpful to be familiar with the tax forms that are used by pass-through entities to business income to their owners.
As covered above, the income and expenses of sole proprietorships and SMLLCs are reported on Schedule C of IRS Form 1040.
A multi-member LLC, S Corporation, or partnership doesn't owe any tax at the company level, but it does have to prepare an informational tax return. For LLCs and partnerships, that return is IRS Form 1065, U.S. Return of Partnership Income. For S Corporations, it's IRS Form 1120S, U.S. Income Tax Return for an S Corporation.
Net income (or loss) for these entities gets calculated on Form 1065 or Form 1120S, but the LLC, S Corporation, or partnership doesn't pay tax on the income. Instead, the income or loss is allocated to the owners through Schedule K-1. The individual owners then report K-1 income on their personal tax returns.
Owners of pass-through entities need to understand three additional aspects of pass-through taxation. First, pass-through taxes are based on the profits of the business, regardless of whether any cash was distributed to the owners. Second, some states impose business taxes on pass-through companies in the form of franchise taxes or annual fees. Third, pass-through owners are subject to self-employment (Social Security and Medicare) taxes.
A pass-through entity's profits are allocated to the owners regardless of whether the company distributes the money. Because of that rule, an owner can end up paying taxes on income they didn't actually receive.
For example, suppose Abby, Barb, and Carla are equal one-third owners of an LLC. The business earns a $90,000 profit this year, but makes no cash distributions to the members (perhaps the cash was needed to fund an expansion of the business). Abby, Barb, and Carla will each receive a K-1 from the LLC showing $30,000 in income, and each will report that amount on their personal tax return. If the personal income tax due on $30,000 is $8,000, each member will be on the hook for that $8,000, even though they received no cash from the business.
To avoid this outcome, many LLC operating agreements require that the company make cash distributions to cover members' personal tax liabilities arising from the profits of the business. But if the company doesn't have enough cash to distribute, each member will need to come up with the money for taxes on their own.
On the other hand, shareholders of a C corporation report and pay personal income tax on business income only if the business pays dividends. This setup avoids the cash-flow issue that pass-through entity owners can face. But the income that allows a C corporation to pay dividends has already been taxed at the corporate level, meaning there's double taxation.
While pass-through entities don't pay federal corporate tax, some states impose a business tax for all incorporated businesses, such as S corporations, LLCs, and limited partnerships. A state might refer to these taxes as a franchise tax, annual fee, or a renewal fee.
Most income for a pass-through entity is subject to self-employment tax, which includes Social Security and Medicare taxes. Each individual owner or shareholder—rather than the business—is responsible for paying self-employment tax. Understand that the rates for Social Security and Medicare taxes are the same for pass-through business owners as they are for C corporations and their W-2 employees. The difference is that the corporation pays half and the employee pays half, while the pass-through business pays none of it and the owner pays all of it.
Choosing S corporation status might allow you to avoid paying self-employment tax on a portion of the business income, with some restrictions.
The steps for forming a pass-through entity will depend on the business structure you choose.
You will automatically have a sole proprietorship, which is a pass-through entity, as soon as you start doing business by yourself (and in some states, with your spouse). Similarly, you form a partnership as soon as you begin doing business with another person. Forming an LLC takes additional steps, like filing formation paperwork with the state, but for tax purposes it will be a pass-through entity by default.
Creating a pass-through corporation requires additional steps. When you form your corporation, it will be a C corporation for tax purposes by default. To elect S corporation status, you must then file additional paperwork with the IRS. (For more information on S Corporations, see Five Questions to Ask Before Forming an S Corporation.)
Avoiding double-taxation of business income might seem like the right strategy for all small businesses. But changes to the corporate tax rules should be considered.
The Tax Cuts and Jobs Act dramatically changed the corporate tax rate to a single flat tax of 21%. Before, corporations used to pay tax rates ranging from 15% to 35%. The 21% rate is lower than individual rates at some income levels.
On the other hand, corporations don't benefit from the 20% QBI deduction described above, which can cut the effective tax rate for pass-through income by 20%.
Under some circumstances—especially if all or most of the profits in the business would be left in the corporation and not distributed as dividends—C corporation status can result in a lower overall tax on business income.
If you're not sure whether pass-through status or C Corporation status is right for your business, consult a business attorney or other tax professional to help you with the decision.