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Starting Your Business: Tax Considerations

 

You’ve decided to start a business in Washington. One of the first choices you’ll need to make is the type of business entity to use. The right fit for you will depend on a number of factors, not the least of which is how the entity you choose will be taxed.

Now, for most people, just the thought of the tax code is enough to put them to sleep. I don’t want you to doze off at your desk, and so I promise you won’t see any citations to the tax code or complex formulas in this post.

Instead, I’ve kept this post to a high-level overview of the default tax classifications for common types of entities, including the following:

 How businesses are taxed
  1. C-corporations

  2. S-corporations

  3. Partnerships

  4. Single-member LLCs

  5. Multiple-member LLCs

Here’s the thing: once you understand the default tax classifications and how they apply to the various types of entities you’re considering, you’re in a much better position to work with your accountant or lawyer or both to decide which entity is best for you.

OK, time to dig in.

Corporations

For tax purposes, there are two types of for-profit corporations: C-corporations and S-corporations.

C-Corporations Are Taxed Twice

The default tax classification for a corporation is the C-corporation. A C-corporation is taxed twice. More precisely, the profits of a C-corporation are taxed at two levels: (1) the entity level when earned, and (2) the stockholder level when distributed.

Despite being subject to two levels of taxation, the C-corporation remains the most common corporate form. The benefits of using a C-corporation include the ability to have multiple classes of stock and unlimited number and types of shareholders, features that are desirable for most large companies and publicly traded corporations. Because institutional investors also find these features desirable, startups seeking venture capital are almost invariably C-corporations.

S-Corporations Are Taxed Only Once

The alternative tax classification for a corporation is the S-corporation. Unlike the C-corporation, the S-corporation is not taxed at the entity level. Instead, its profits and losses “pass-through” to stockholders to report, according to their respective share, on their own tax returns. In short, an S-corporation is taxed only once.

However, a businesses is only eligible for S-corporation status if it has one class of stock, 100 stockholders or less, and (subject to limited exceptions) only U.S. citizens or residents as stockholders. For this reason, S-corporations are typically not a good choice for companies intending to raise venture capital and chase growth.

Partnerships Are Taxed Like S-Corporations

Unless it elects a different classification, a partnership entity will be taxed as a partnership. A business taxed as a partnership is, like an S-corporation, a “pass-through” entity, meaning it isn’t taxed at the entity level. Its profits and losses pass-through to the partners to report, according to their respective share, on their own tax returns.

If a business wants pass-through treatment, but isn’t eligible for S-corporation classification, it often elects to be taxed as a partnership. The reason for this is that a partnership doesn’t have limits on the number, type, or residency of the owners of the business.

Additionally, a business that’s taxed like a partnership can generally divide profits however it chooses, whereas a business that’s taxed as an S-corporation must divide profits according to share ownership.

A partnership entity can elect C-corporation status but usually doesn’t. Nevertheless, a partnership entity may still be taxed as a C-corporation if it a “publicly traded partnership” (PTP). A PTP will be taxed like a C-corporation if less than 90% of its gross income consists of certain types of passive investment income.

LLCs

For tax purposes, LLCs can be divided into two categories: single-member LLCs and multiple-member LLCs. Note, though, that there is no federal income tax arrangement specific to LLCs, leaving them with increased flexibility to choose how they’re taxed. When you’re ready to form an LLC, consult our step-by-step guide.

Single-Member LLCs Are Taxed Like Individuals

Unless it elects a different classification, a single-member LLC will be taxed as a “disregarded entity.” A disregarded entity isn’t treated as separate from its owner for tax purposes. So, the single owner of the entity reports the entity’s income and expenses on its own income tax return, rather than filing a separate federal income tax return for the entity.

In addition, a single-member LLC can elect S-corporation status, assuming it meets the S-corporation requirements, or it can elect C-corporation status.

Multiple-Member LLCs Are Taxed Like Partnerships

Unless it elects a different classification, a multiple-member LLC will be taxed as a partnership. Recall that a business taxed as a partnership is treated as a pass-through entity, meaning profits and losses pass-through to the members of the LLC to report, according to their respective share, on their own tax returns.

However, even if a multiple-member LLC is technically classified as a partnership, it may nonetheless be taxed as a C-corporation if it is a PTP and less than 90% of its gross income consists of certain types of passive investment income.

While multiple-member LLCs often choose to be taxed as a partnership, they can elect S-corporation status, assuming they meet the S-corporation requirements, or they can elect C-corporation status.

Reflections

Having a basic grasp of tax classifications can help you choose the entity that’s right for your business. But knowing the basics is just the start. Entity taxation is a complex subject, and most businesses would be wise to consult with a CPA and/or an attorney for advice on which type of tax treatment best fits with the company’s particular needs.

If you still have questions about entity taxation, you can leave a comment below or contact us directly.

Photo: GotCredit | Flickr