Business Entity Taxation

One way or another, all for-profit business entities pay taxes. However, they are not all treated the same under the Internal Revenue Code. For this reason, it is not only important to understand the significant differences between the various types of legal business entities but also how those entities are treated under the Internal Revenue Code. Taxes matter. To learn more, contact a business attorney.

Sole Proprietorship

Sole proprietors declare their business income on their personal tax returns and are taxed at their individual income tax rate. Sole proprietors also pay the FICA (Social Security and Medicare) payroll tax of 15.6% on all income.


A partnership is a pass-through entity, meaning its profits pass-through the partnership to the partners according to each partner’s interest in the partnership. The partners then declare their share of income on their personal tax returns and are taxed at their individual income tax rate. Partners also pay the FICA payroll tax of 15.6% on all income. Partners are not employees of the partnership and are not issued a W-2 wage statement.  Rather, partners are issue Schedule K-1 statements.

Limited Liability Company

Limited liability companies, also known as LLCs, are pass-through entities. As with the sole proprietorship and partnership, an LLC’s profits and losses pass through the entity to its members according to each member’s interest in the LLC. Members then declare their share of income on their personal tax returns and are taxed at their individual tax rate. Members also pay the FICA payroll tax of 15.6% on all income. Unlike sole proprietorships and partnerships, LLCs can elect to be taxed as S-Corporations, which are discussed in more detail below.


Under the Internal Revenue Code, corporations may be taxed as C-Corporations or S-Corporations. The C-Corporation is the standard corporate structure. When articles of incorporation are filed, the default entity will be a C-Corporation. Because the C-Corporation is an entity separate and distinct from its owners, the C-Corporation pays income taxes on its earnings. This takes place before distributions are made to shareholders. As a result, C-Corporations are subject to double taxation: the C-Corporation pays taxes on its income and shareholders pay taxes on all distributions made by the C-Corporation. However, because the C-Corporation has already paid taxes on its income, qualified dividends are taxed to shareholders at the more preferential qualified dividend tax rate. Shareholder-employees of C-Corporations are also subject to personal income taxes and theFICA payroll tax on all wages earned as a corporate employee. The shareholder-employee pays 7.65% of the FICApayroll tax while the C-Corporation pays the remaining 7.65%.

The S-Corporation is similar to the C-Corporation in formal structure. The difference is that C-Corporations are treated like pass-through entities under the Internal Revenue Code. As pass-through entities, their earnings pass through the corporation directly to shareholders in proportion to each shareholder’s ownership interest in the corporation. The shareholder then declares the income on his/her personal income tax return and is taxed at his/her individual rate. The S-Corporation does not pay taxes on its income. As a result, the S-Corporation is not subject to double taxation. When a shareholder is actively engaged as a shareholder-employee of an S-Corporation, the shareholder does not pay Self-Employment Taxes on wages earned. Rather, the shareholder-employee is paid a salary and his/her wages are reported on a W-2. FICA taxes are withheld with the shareholder-employee paying 7.65% and the S-Corporation paying the remaining 7.65%. At the end of the tax year, the shareholder-employee receives two tax documents from the S-Corporation: a W-2 wage statement and a Schedule K-1 statement.

Shareholder-employees are taxed on their wages and all distributions made by the S-Corporation. Unlike a C-Corporation‘s distributions, the S-Corporation‘s distributions are taxed as ordinary income to the shareholder rather than qualifying dividends. Again, this is due to the fact that S-Corporations are pass through entities who pay no taxes on their incomes. However, the S-Corporation‘s profit distributions are not subject to FICA payroll taxes. Because the S-Corporation and shareholder-employee pay the FICA payroll tax on wages, shareholder-employees face a strong temptation to pay a minimal salary and a higher distribution to reduce overall taxes paid. The IRS actively seeks out S-Corporations paying below-average wages to share-holder employees. When establishing salaries for S-Corporation employees, the Board of Directors should establish what the IRS terms a “reasonable compensation” for services rendered.

Not all corporations can elect to be taxed as S-Corporations. This status is limited to corporations with 100 or fewer members and only one class of stock.  In order to receive S-Corporation tax status, the corporation must formally elect to be an S-Corporation by the 15th day of the third month of its tax year. If the election is not timely made, the corporation will be taxed as a C-Corporation. As previously stated, LLC’s may elect to be taxed as S-Corporations under the Internal Revenue Code. To discuss your business needs in more detail with a business attorney, contact Blehm Law.