Tax implications of business structures: Sole
proprietorships, partnerships, and S corporations
INTRODUCTION
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
When starting a new business, one of the most important decisions an
entrepreneur will make is what legal structure to use. The choice of structure
has wide-ranging implications for the business's taxes, liability, ownership,
operations, and succession planning. This paper will explore the key tax
consequences of operating as a sole proprietorship, general partnership,
limited partnership, limited liability partnership, or S corporation.
Understanding the tax treatment under each structure will help business
owners choose the optimal form based on their goals and circumstances.
SOLE PROPRIETORSHIPS
A sole proprietorship is the simplest and most common business structure
where an individual owns and operates the business as an unincorporated
entity. There is no legal distinction between the owner and the business
itself. Tax considerations for sole proprietorships include:
Income Reporting - All income and expenses from the business are reported
on the owner's personal income tax return using Schedule C. Net business
income or loss passes through to the owner's Form 1040.
Self-Employment Taxes - Sole proprietors must pay both the employee and
employer portions of Self-Employment Contributions Act (SECA) taxes which
is equivalent to the combined Social Security and Medicare taxes for regular
employees and their employers. Currently the SECA tax rate is 15.3% on the
first $147,000 of net earnings.
Deductions - Business expenses including healthcare costs are deductible
from gross receipts to arrive at net income. Owners can also deduct half of
their self-employment taxes as an adjustment to income on their Form 1040.
Losses - Any net business losses can offset other income like salaries,
interest, dividends and capital gains reported on Form 1040 to lower overall
taxable income. Excess business losses are currently subject to limitation
under the Tax Cuts and Jobs Act (TCJA).
Fringe Benefits - Sole proprietors cannot deduct the costs of health insurance
or retirement plans for themselves as the owner since they are not
considered employees. However, they qualify for 100% deductibility of
healthcare premiums as an adjustment to income.
GENERAL PARTNERSHIPS
A general partnership involves two or more individuals carrying on a trade or
business as co-owners. Key tax attributes for general partnerships include:
Income Reporting - The partnership itself does not pay income tax but must
file an informational Form 1065. Partners include their distributive share of
partnership income or loss on their individual Form 1040 based on the
partnership agreement.
Self-Employment Income - General partners treat their distributive share of
income or loss as self-employment earnings subject to SECA taxes, allowing
for deduction of legitimate business expenses.
Basis Adjustments - A partner's outside tax basis is increased for income
allocation and decreased by loss allocation and cash distributions to ensure
potential gain/loss from a liquidating sale is properly captured.
Sale of Partnership Interest - Absent a Section 754 election for partnership
asset basis adjustment, the sale of a partnership interest results in ordinary
income/loss to the selling partner rather than capital gain/loss.
At-Risk Limitations - Under IRC 465, partners can only claim loss deductions
up to the amount they have personally invested in the partnership plus any
amounts they are personally liable for partnership debts.
Passive Activity Losses - General partners can treat losses from partnership
operation as non-passive losses to offset other types of income. Losses are
limited for limited partners under IRC 469 "passive loss" rules.
LIMITED PARTNERSHIPS
A limited partnership also involves at least one general partner who
manages the business and has personal liability and one or more limited
partners who have limited liability and limited involvement in management.
Tax considerations include:
Limited Liability - Limited partners are not personally liable for partnership
debt or lawsuits beyond their investment amount. General partners have full
liability like in a general partnership.
Passive Loss Treatment - Limited partners cannot deduct losses from the
partnership against salary or portfolio income and can only deduct passive
losses against passive income earned in other activities. General partners
can treat their distributive share of income/loss as non-passive.
Income/Loss Allocation - Distributive shares of partnership income/loss pass
through and are reported on the partners' individual tax returns in the same
manner as a general partnership.
Self-Employment Income - General partners continue to treat their share of
income/loss as self-employment income while limited partners do not owe
self-employment tax absent guaranteed payments for services.
Basis Adjustments - Same as for general partnerships with partners' outside
basis being adjusted annually for their distributive share of income/loss and
cash distributions.
Estate Tax Valuation - Estate tax consequences depend on the existence and
terms of partnership agreement buy-sell provisions, partnership restrictions
and discounts for lack of control and marketability that may reduce value.
LIMITED LIABILITY PARTNERSHIPS
A limited liability partnership (LLP) is a general partnership that provides
limited liability for all partners unlike a standard general partnership where
partners have unlimited personal liability. Key tax attributes include:
Flow-Through Taxation - The LLP itself is not a taxable entity and income or
loss flows through to be reported on the partners' individual returns based on
partnership agreement allocations.
Self-Employment Income - Partners continue to treat their distributive shares
of partnership income as self-employment earnings subject to SECA taxes,
equivalent to combined Social Security and Medicare taxes.
Limited Liability for Debts - All partners have limited personal liability
protection from creditors claims against the LLP for partnership debts or
obligations in the same manner as limited partners.
S CORPORATIONS
An S corporation has tax advantages of a partnership like income taxed only
at the shareholder level while providing liability protection like a regular C
corporation. Key tax considerations for S corporations include:
Income/Loss Pass-Through - Like partnerships, an S corporation does not pay
tax but passes through profits and losses to shareholders to be reported on
their individual returns based on stock ownership. This avoids double
taxation.
Salary Distributions - Reasonable salaries paid to shareholder-employees
must be paid out in order to receive corresponding tax deductions by the S
corp. Excess distributions may be challenged as disguised dividends.
Shareholder Basis - A shareholder's outside tax basis or cost is adjusted
annually for their share of S corp income or loss to determine if distributions
can be received tax-free or will be taxed as capital gain. Basis tracking
avoids double taxation.
Fringe Benefits - Shareholder-employees can receive tax-exempt health
insurance and other fringe benefits not available to sole proprietorships or
partners. Benefits must be non-discriminatory.
Employment Taxes - Shareholder-employees pay self-employment tax on
their salary/reasonable compensation income but not on any pass-through S
corp income or distributions in excess of compensation.
Built-In Gains Tax - An S corp that was previously a C corporation faces a
built-in gains tax if appreciated assets that caused a potential gain
recognition event while still a C corp are sold within 10 years after S election.
S Corp Termination - Termination of an S election triggers potential taxation
of built-in gains that existed prior to termination at the corporate level.
Careful planning around S election eligibility is required.
CONCLUSION
The tax implications under each business structure vary widely and require
consideration of the entity's operations, form of ownership, liability concerns
and succession or exit plans. Sole proprietorships offer maximum flexibility
but limited liability while S corporations provide liability protection with pass-
through taxation. Partnerships address multi-owner operations. Proper
structure selection based on an entity's specific needs ensures optimal tax
treatment and minimizes compliance complexities down the road. Planning
with tax and legal advisors is recommended when launching a new business.
