The main types of business entities and their respective tax treatments are described below.
Sole Proprietorship: A business that is owned by one person and is not incorporated. (Tax treatment for self-employed persons or independent contractors is similar to that for sole proprietors.) For tax purposes, the income and expenses from the business are reported on the owner’s income tax return, and the owner pays self-employment tax. The owner may also be responsible for excise tax, estimated tax and employment taxes.
Partnership: A business owned by two or more persons or entities that share in the profits and losses. The partners are not employees of the business but rather are considered self-employed. For federal tax purposes, the partnership must file an informational return that reports operational profits and losses, and the partnership is responsible for employees’ employment taxes and any excise taxes. The income tax that the partnership generates “passes through” to the individual partner’s tax return based on each partner’s share of the business. The individual partner is responsible for income tax, self-employment tax and estimated tax.
Corporation: A corporation is an entity formed by adhering to certain formalities such as filing articles of incorporation with the state, creating bylaws, exchanging capital stock for shareholder money or property, creating a board of directors and holding a meeting of the board of directors. For tax purposes, the corporation makes deductions similar to those for a sole proprietorship but has a double taxation aspect in that profit is taxed both to the corporation when incurred and also to the shareholders when distributed as dividends. Shareholders may not deduct corporate losses.
S Corporation: An S Corporation is a corporation whose shareholders avoid the double-taxation aspect of a regular corporation. The shareholders would be responsible for federal income tax due for certain capital gains and other passive income.
Limited Liability Company: An LLC is formed under the requirements of state law by filing articles of organization with a secretary of state. It has attributes of both a corporation and a partnership, and its owners are referred to as members. For tax purposes, by default, if an LLC has only one member, it’s treated as a sole proprietorship. If it has more than one member, the tax treatment defaults to that of a partnership. In both instances, an election may be made to treat the LLC as a corporation.
Employers are responsible for making deductions for Social Security tax, Medicare tax and federal unemployment tax. Social Security and Medicare taxes apply to all wages for work conducted by employees in America and in some instances for work performed outside of America. The taxes are deducted from employees’ pay and provide retirement and medical benefits under the Social Security system.
The Federal Unemployment Tax Act funds a federal and state program that provides unemployment pay to workers who are unemployed because of lost jobs. The tax is the employer’s responsibility and is not deducted from an employees’ pay.
Last update: Sept. 29, 2008