Different Types of Business Entities and Their Tax Implications

July 29, 2011 by  Filed under: Taxes 

The module that you choose to operate your business as affects both your tax liability and tax reporting. Besides the tax implications, there are also other legal implications associated with each business entity. Therefore, before settling on a business module, you should review the implications and settle on the model that best fits it. You can also change the business entity with time if you feel that it is better for your business. Below are some of the business entity options that you can opt for:

Sole Proprietor

The sole proprietor is the most common type of business entity used by taxpayers. On average, over 70% of business tax returns are sole proprietor returns. In this business model, the taxpayer runs a business under his or her name and files tax returns for it under his or her name. One’s personal Form 1040 is therefore used to file the business returns. Sole proprietors are easy to start and run, as there are minimal legal requirements to operate one. The business is owned by one individual and there is no legal separation between the business and the owner. The tax authorities do not require professional books of accounts, but instead, require a consistent way of recording and accounting for incomes as support documentation for the tax returns.


About 8% of the business tax returns filed every year are from partnership business entities. A partnership is owned by more than one owner. A general partnership will require a partnership agreement that governs the operation of the business. Unlike sole proprietor businesses, a partnership requires proper double entry accounting records to show incomes and expenses for taxation. The share of the partnership profits should also be tracked in the business accounts. A partnership business return is filed under Form 1065 and each partner is expected to file their share of the profits in their individual Form 1040 and pay the respective taxes.

C- Corporations and S-Corporations

The C-Corporations and S-Corporations enable small businesses to operate with limited liabilities. Various state laws govern and regulate the operations of these types of corporations and therefore, you will need to refer to your specific state to know the applying rules. However, the S-Corporation is required to file an IRS Form 2553 at its inception. An S-Corporation is easy to change to a C-Corporation; a partnership or a limited liability company will little to no tax implications. However, for the C-corporations, changing to another type of business entity may have significant tax implications. C-corporation also has complex accounting books requirement for tax purposes. The C-Corporation tax returns are filed separately under the business name using Form 1120 and the appropriate taxes will be paid. The shareholders’ dividends are then taxed on the shareholders’ tax returns. This is unlike the S-Corporation, where the business entity is not taxed and taxes are charged once at the shareholders’ level. However, being state governed, the taxation process is slightly more complex with these business entities and you may want to consider professional tax help to handle these taxes.

Limited Liability Company (LLC)

The limited liability company is a more recent business entity in America, having been first introduced in the U.S. in 1977 in the state of Wyoming. The business entity can either be owned by one person or more. The legality of the business model is governed by the state law, and you may need to find out the specific rules that govern LLCs in your state. One of the major characteristic of this business model is that it does not have a tax classification. This means that the owner or owners of the business have the option to elect the business model to which they wish to file their returns. They can opt to file taxes as a partnership, a corporation, or an association. For single owner LLCs, the owner can choose to file taxes as a sole proprietor. Whichever tax vehicle that the owner or owners of the LLC choose to file returns, they must adhere to the rules that govern the respective business entity.

Rob L Daniel and partners of Limon Whitaker & Morgan, for years have helped businesses and individuals Nationwide, with their delinquent IRS & State tax problems. The firm is based in Los Angeles, California USA.


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