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 can't
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 can't 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.
The form of business that is established can give rise to tax-related implications. When selecting
a sole proprietorship as the tax reporting entity for a new business, the main advantage is simple
tax rules, as the business income is reported on the proprietor’s personal income tax return
(Cooper, 2016). A major disadvantage is the personal liability of the owner. In a sole
proprietorship business, the owner takes the profit as his income, on which he has to pay tax just
as on his main income.
The main advantage of selecting a partnership as a tax reporting entity is the easy set-up process
and simple taxation on the business income, which is considered as the personal income of the
partners. However, the main disadvantage is the personal liability of the partners in case of debts
or financial obligations (Tunnell, 2020). The payment of profits to owners is distributed as the
personal income of the partners. The tax is reported on the income tax returns of each of the
partners of the partnership business.
When a corporation form of business is chosen for a tax reporting entity, the chief advantage is
that it has a distinct legal identity which restricts the personal liability of the owners. The main
disadvantage is a complex taxation process due to the application of the double taxation method,
where the corporate has to pay tax on the income, and the shareholders must pay tax on dividends
(Larisa, 2020). This taxable entity accounts for payments to owners in the form of salaries,
remuneration, wages and dividends and they are considered the personal income of the owners on
which tax is computed.
While opening a chain of gas stations along with three other investors, the type of business entity
that would be best to handle the tax reporting for the business is ‘partnership.’ The partnership
has been chosen as the ideal business type since it can be easily formed due to minimal
compliance and formality requirements. Each of the partners would have control over the
decision-making process and take vital decisions promptly (Efremova, 2020). In a partnership
business, the taxation method is simple since the business income would be the personal income
of each of the partners based on the predetermined ratio. The possibility of double taxation could
be avoided, which would otherwise arise in the case of a corporate form of business. The tax on
the income would be charged as the normal tax returns that are paid by the partners for their other
or normal income.
References
Aleksandrovna Efremova, T. (2020). Developing tax administration in the context of the
partnership of participants of Tax Relations. 3C Empresa. Investigación y Pensamiento Crítico,
9(3), 109–123. https://doi.org/10.17993/3cemp.2020.090343.109-123
Cooper, M., McClelland, J., Pearce, J., Prisinzano, R., Sullivan, J., Yagan, D., Zidar, O., &
Zwick, E. (2016). Business in the United States: Who owns it, and how much tax do they pay?
Tax Policy and the Economy, 30(1), 91–128. https://doi.org/10.1086/685594
Larisa, A. A., Fatima, S. A., & Madina, T. A. (2020). Double taxation: Concept, causes and
procedure for elimination. European Proceedings of Social and Behavioural Sciences.
https://doi.org/10.15405/epsbs.2020.10.05.170
Tunnell, L., & Ricketts, R. (2020). Taxation essentials of llcs and partnerships.
https://doi.org/10.1002/9781119722304
Anderson, Kenneth, et al., editors. Pearson’s Federal Taxation 2023 Corporations, Partnerships,
Estates & Trusts. Pearson Education, Inc, 2023.
