Understanding the Differences in Taxation of S-Corps, Partnerships, and Sole Proprietorships at the Federal Level
- Sole Proprietorship
- Pass-Through Taxation: As a sole proprietor, you report all business income or losses on your personal tax return (Form 1040) using Schedule C. This income is subject to federal income tax and self-employment tax, which covers Social Security and Medicare contributions.
- Self-Employment Tax: The entire net income from your business is subject to self-employment tax at a rate of 15.3%, which includes both the employer and employee portions of Social Security and Medicare.
- Qualified Business Income Deduction: Sole proprietors may also qualify for a 20% deduction on qualified business income (QBI), which can reduce taxable income.
- Partnerships
- Pass-Through Taxation: Similar to a sole proprietorship, a partnership does not pay income tax at the business level. Instead, each partner reports their share of the partnership’s income or loss on their personal tax return, using the information provided on a Schedule K-1 (Form 1065). This form details each partner’s share of the partnership’s income, losses, deductions, and credits.
- Self-Employment Tax: General partners are subject to self-employment tax on their share of partnership income, while limited partners typically are not unless they are actively involved in the business’s operations.
- Flexibility in Profit Sharing: Partnerships offer flexibility in how income and losses are allocated among partners, which can be an advantage depending on the specific agreement between the partners.
- S-Corporations (S-Corps)
- Pass-Through Taxation with K-1 Reporting: Like partnerships, S-Corps are pass-through entities, and income, losses, deductions, and credits are reported on each shareholder’s personal tax return. Shareholders receive a Schedule K-1 (Form 1120S), which outlines their share of the corporation’s income, losses, deductions, and credits.
- Self-Employment Tax Savings: Shareholders who are active in the business must receive a “reasonable” salary, which is subject to payroll taxes. However, any remaining profits distributed as dividends are not subject to self-employment tax, potentially leading to tax savings. This aspect makes S-Corps particularly attractive for small business owners.
- Reasonable Compensation Requirement: The IRS requires that owner-employees of S-Corps be paid a reasonable salary for their services, preventing the avoidance of payroll taxes by taking minimal salaries and large dividends.
- Always consult with a tax professional for professional advice.
Matthew Bluzer, EA
