By Robert M. Finkel and Diana C. Española
July 2010
Businesses can be operated through a variety of entities or through no entity at all. An individual who operates a business as a sole proprietorship without forming an entity will be directly taxable on the business income and gain, and, subject to certain limitations, be able to offset income and gain with the loss and deduction from the business. The individual reports the sole proprietorship’s income, gain, loss and deduction on his or her federal and state tax returns. Two or more individuals who operate a business without forming an entity will be taxed as a partnership. Partnerships themselves are not subject to income tax. Rather, income, gain, deduction and loss generated by the partnership are reported by each partner on his or her federal and state tax returns as allocated by the partners.
Most entrepreneurs, however, choose to operate through an entity, such as a corporation or a limited liability company (“LLC”) for business reasons, including the limitation of liability. Operating through an entity can also facilitate changes in ownership and investments by others. While there are numerous non- tax factors to consider when choosing which form of entity to use, there are also many tax considerations.
For example, for tax purposes, corporations may be classified as C corporations or S corporations. C corporations are separate taxable entities for federal and state income tax purposes. A C corporation pays an entity-level tax on its income and gain and only the C corporation may take advantage of any loss and deduction it generates. A C corporation’s owners (shareholders) pay another tax on the corporation’s distribution of corporate earnings and profits when distributed as a dividend. Unlike a C corporation, an S corporation is not a separate taxable entity for most federal and state income tax purposes. The S corporation’s owners (shareholders) pay tax on a proportionate share of the income and gain realized by the company (whether or not it is distributed to them) and may, subject to certain limitations, use the entity’s losses to offset other income. There is no tax upon the distribution. Not every corporation, however, is eligible to be an S corporation.
An LLC is like an S corporation in that it is not a separately taxable entity for most federal and state income tax purposes. If an LLC has only one member it is generally taxed like a sole proprietorship. If it has more than one member it is generally taxed under the rules applicable to partnerships. Multi-member LLCs are not separately taxable; its owners (members) are taxed on their allocable share of the company’s income and gain (whether or not it is distributed to them) and may, subject to certain limitations, use the entity’s losses to offset other income. As with S corporations, the owners are not taxed when the previously taxed income and gain is later distributed.
While overall income tax burden on a business is an important factor, there are other important non-tax differences between C corporations, S corporations and LLCs. While some of the tax considerations described in this article may tip the balance when choosing an entity under particular facts and circumstances, it is impossible to know (without serious computer modelling and a crystal ball) exactly which form will result in the lowest overall tax burden. It is possible, however, to be aware of the major tax differences to avoid surprises and prepare accordingly.
The following article summarizes some of these differences in three broad categories:
Other business entities include limited partnerships, business trusts and specialized entities such as real estate investment trusts (REITS) and real estate mortgage investment companies (REMICS). These are not addressed in the article.
The above is background and introductory information; to access the full contents of this article, download it as a PDF by clicking on this link: Basic Tax Issues in Choosing a Business Entity. 
For more information on tax issues for your business, please contact the authors Robert M. Finkel or Diana C. Española.
This article is not intended to constitute legal or tax advice and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing or recommending any transaction or matter addressed herein.
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