When determining in which way you should organize a business, one should consider the
different advantages and disadvantages and align them with the businesses' taxable and
non-tax objectives. There are multiple ways to form a business including sole
proprietorships, partnerships, and corporations.
Sole proprietorships are owned by an individual and earned income is taxed at the
owner's marginal rate. A 20% qualified business income deduction may be applied to
profits. A corporation tax rate may be higher than the proprietor's marginal tax rate thus
providing a tax advantage. Since aligned with the proprietor, money belongs to the
owner and they may withdraw and deposit money without a taxable consequence. Also,
the owner may contribute or withdraw property without having to record a gain or loss.
If the business records a loss the owner can use it to offset non business income.
Disadvantages include not being able to retain earnings which is a limitation on tax
planning as income and losses cannot be differed. You cannot determine your fiscal year
but must adhere to the calendar year, which also could limit tax planning. Owners are
not treated as employees which disqualifies them from non-taxable advantages such as
group life insurance and non-deductible compensation as well as having to pay individual
and employee portions of Social Security and Medicare taxes. If the proprietor's
marginal tax rate is higher than the corporate tax rate it creates tax disadvantage.
Partnerships share a lot of the same advantages and disadvantages as sole
proprietorships but are used by multiple owners with limitations on offsetting losses and
exceptions on gains and losses of property.
Unlike sole proprietorship and partnerships, C Corporations are subject to double
taxation but reduce the shareholders liabilities. They are taxed upon distribution of
income through dividends and when shareholder sell stock. While sole proprietorships
and partnerships can lose busine and personal assets C Corporations limit the
shareholders' personal liability. They treat shareholders as employees which are entitled
to the benefits above that sole proprietorships and partnerships are excluded from. They
can determine their own fiscal year and retained earnings. Shareholders don't benefit
from C Corporations losses in the current year, but losses can carry back and forwards
offsetting in other years. Shareholders also have different benefits determined on how
long they hold the stock.
S Corporations are treated like a partnership. They are taxed once as the corporate
income is passed to the shareholders and taxed to the shareholders. Like a partnership,
they may qualify for a 20% deduction, there is an advantage or disadvantage depended
on if the shareholder's marginal tax rate is higher or lower than the corporate tax rate.
Shareholders do not have to recognizes gains and losses upon contributing or
withdrawing money. S Corporations are not subject to self-employment tax. Gains are
taxed as if the shareholder directly realized them at their capital gains rate, but this can
offset other sources of capital losses. Generally, S Corporations cannot defer income like
C Corporations unless there is a business purpose that is legitimate.
There are different scenarios as to use the different business formations. One must
consider the advantages and disadvantages that apply to each and how they benefit the
business being formed. For example, Gary is retired with a low marginal tax rate and is
looking to start a business based on his hobby of restoring cast iron skillets and selling
them. Since it is a hobby, he is simply looking to take advantage of a business formation
that would reduce his taxes given that he typically has a large inventory with a low
turnover rate. A tax advisor might suggest a sole proprietorship given that Gary more
likely than not will lose money if not break even thus allowing him to reduce his taxes.
This should allow Gary to take advantage of his hobby and offset his traditional 401k
withdraws.
References
Anderson, Kenneth, et al., editors. Pearson’s Federal Taxation 2023 Corporations,
Partnerships, Estates & Trusts. Pearson Education, Inc, 2023.
