As an Enrolled Agent, I often ask new clients, what type of business structure they have and how do they file their taxes?  They often can’t answer this question because of the confusion between the federal tax structures and the state legal structures.

The most common types are usually listed as sole proprietorship, partnership, LLC or Limited Liability Company, S-Corporation, and C-Corporation. This is mixing tax entity types with legal entity types. There is a complicated, intertwined mix of tax and non-tax laws but I will simplify it for you.

I’ll start with a summary.  An LLC is not a structure under the Tax Code. Therefore, there is no tax form for filing an LLC’s tax return. An S-Corp is a structure for tax purposes.

                                            Legal Protection                        Tax Situation

C-Corporation                Separate entity,                         Taxed as separate entity,

                                            owners not liable                        Corporation pays taxes

S-Corporation                Separate entity,                         Does not pay taxes.

                                             owners not liable                    Profits passed through to

                                                                                                   owners and taxed on 1040.

Partnership               Owners generally have             Does not pay taxes.

                                        no liability protection               Profits passed through to 

                                                                                                  owners and taxed on 1040.

Sole Proprietorship    Owners generally             Does not pay taxes.

                            have no liability protection        Profits passed through to

                                                                                            owners and taxed on 1040

LLC                            Owners have liability             Not a tax entity.

                                        protection                                Default is treat like

                                                                                              partnership or sole

                                                                                              proprietorship. Option to

                                                                                              be taxed like C-Corp.

Corporations are separate entities. In other words, the corporation is separate from the owners or shareholders.  This separation is for taxes and liabilities. It can be breached if the owners comingle finances, property, loans, etc. For tax purposes, corporations are C-corps and file using form 1120. They pay their own taxes.

Many corporations can elect to be taxed as S-Corporations, but there are some limits on the number and type of shareholders for S-Corps. The S-Corp election results in the profit and losses passing through to the owners. The S-Corp uses form 1120S and provides the pass-through information to the owners using form K-1. The profits and losses are included on the owners’ tax return. Owners can be employees of the company and therefore, receive income. People used to select S-Corp as their business tax structure to save on Social Security contributions. These owners would pay themselves a low wage (subject to Social Security) and then pay the rest of the profits as dividends (not subject to Social Security). The laws and regulations changed and owner-employees must pay themselves a reasonable salary for the work they provide.  If you were making $150,000 doing a job and then started a business doing that same work, your S-Corp should pay you a salary of about $150,000.

A partnership is a company with at least two owners and the owners are liable for the business. If there are two partners and one departs, the partnership closes and the business becomes a sole proprietorship. Changes in ownership, even with more than two owners, can cause the partnership to terminate. The profits and losses of a partnership are passed through to the owners. The partnership completes a 1065 form and sends the owners K-1 forms showing the profit (loss) to claim on their personal tax return. Unlike an S-Corp, the owners cannot be employees. All the profits are passed through as income and subject to Social Security contributions.

Side note:  Being in a partnership is often equated to being married.  You need to pick your partners well and write a good agreement for handling situations including termination of agreement, sharing of profits and losses, contributions of funds and property for the business to run, etc.

A sole proprietorship is a company owned by one person. There is no liability protection. The profits and losses are all passed through to the owner. The business information is put on a Schedule C form and the resulting profit is listed on the 1040 form. The Schedule C is filed with the 1040. If the owner dies, the business is terminated. The assets, name, building, etc, may be transferred to a new owner and continue to operate, but for legal and tax purposes, it is a new business. 

An LLC is allowed by state statute and each state has it’s own regulations for LLCs. The federal government does not view the LLC as a separate entity from its owners but the LLC status provides a level of liability protection to the owners. As with corporations, these protections are limited if the owners comingle their personal lives with the business. An LLC with two or more members (i.e., owners) is treated like a partnership for tax purposes. An LLC with only one member is treated like a sole proprietorship for tax purposes. Any LLC can elect to be treated like a corporation for tax purposes which then allows the company to be treated like a C-Corp or an S-Corp.

This is a simplification. There are many nuances. As with most legal and tax-related issues, the devil is in the detail and each case is different.  There are several things to know about tax ID numbers for sole proprietors and LLCs. There are limits on the type of businesses that can be an LLC. Books have been written about this topic. Please remember this is a simplified and short version of the information.