As I mentioned in my last post, business organizations have greater flexibility in choosing how they’re taxed than sole proprietors do. This topic can be confusing at first, because we’re talking about two different levels of law—Illinois law and federal law—that both use some of the same terms, like “corporation” or “partnership,” but mean different things. Under Illinois law, a business owner who wants a business organization is likely to form a corporation, limited liability company (LLC), or some kind of partnership, such as a limited partnership or a limited liability partnership. Under federal law, that business organization might be taxed as a C corporation, an S corporation, a partnership, or a disregarded entity. But an LLC formed under Illinois law might choose to be taxed under federal law as an S corporation or as a partnership!
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To help clear up some of the confusion, let’s look at the four types of federal tax structure and which business organizations can choose which structures.
Income tax: A business organization that is taxed as a C corporation files its own tax return (Form 1120) and pays its own taxes using a corporate tax rate. When the business organization distributes its profits to its owners, the owners must report those distributions as dividends on their own tax returns (Form 1040) and pay tax on them.
Employment tax: If an owner of a business organization taxed as a C corporation is also an employee of the organization, then he will be liable for half of FICA taxes on earnings, and the organization will pay the other half.
What business organizations qualify: Corporations, LLCs, and partnerships.
Income tax: A business organization that is taxed as an S corporation must file what’s known as an information return (Form 1120S), but it doesn’t pay its own taxes. Instead, the income of the business organization is “passed through” to its owners, who report a share of the income in proportion to their ownership of the company on their own tax returns and pay taxes on it at their individual tax rates. The business organization will mail Forms K-1 to the owners, telling them how much income to report on their tax return. Because the business organization’s income is taxed to its owners, distributions from the business organization are not subject to income tax.
Employment tax: If an owner of a business organization taxed as an S corporation is also an employee of the organization, then she and the organization will split liability for FICA taxes. However, there is some flexibility in determining whether payments to an owner/employee are wages, which are subject to FICA taxes, or distributions, which are not.
What business organizations qualify: Corporations, LLCs, and partnerships, but only if they satisfy certain ownership restrictions.
Income tax: The partnership tax structure also passes through its income to its owners, so much of what was just said about S corporations applies here. The business organization files an information return (Form 1065) and mails Forms K-1 to the owners to report their shares of income on their individual tax returns.
Employment tax: The owner of a business organization taxed as a partnership cannot be an employee of the partnership. Instead, he will pay self-employment tax on the net income that is passed through to him.
What business organizations qualify: Multi-member LLCs and partnerships.
Income tax: A business organization treated as a disregarded entity is ignored for federal tax purposes. The sole owner treats the business like a sole proprietorship when reporting and paying federal tax. Thus, the owner reports the business income and deductions on Schedule C of Form 1040, and pays income tax on the net income.
Employment tax: As with a sole proprietor, the owner of a business organization treated as a disregarded entity pays self-employment tax on her net business income.
What business organizations qualify: Single-member LLCs.
Choosing a Tax Structure
Federal law sets a default tax structure for each type of business organization. Corporations are treated as C corporations by default, single-member LLCs are disregarded by default, and multi-member LLCs and partnerships are treated as partnerships by default. The business organization files a special form with the IRS to choose a different tax structure.
Hopefully this post has cleared up some of the confusion about this topic, but if you’re still confused, or if you’d just like to discuss which tax structure is right for your business organization, contact Legal Ally today!