Business Entity Taxation

Choosing the right business entity is one of the most important tax planning decisions a business owner can make. The entity structure affects not only income taxation but also liability protection, ownership flexibility, and exit strategies. CFP professionals must understand these distinctions to provide comprehensive planning advice.

The Five Major Business Entities

Sole Proprietorship

A sole proprietorship is the simplest and most common business structure. The business has no legal separation from its owner.

Tax Treatment:

• Business income and expenses reported on Schedule C (Form 1040)
• Net profit flows directly to the owner's Form 1040, Line 8
• Subject to both income tax and self-employment tax
• No separate entity-level tax return required

Key Characteristics:

• Unlimited personal liability for business debts
• Easy to establish with minimal formalities
• All profits belong to the owner
• Business ends upon owner's death

Partnership (General and Limited)

A partnership exists when two or more persons carry on a business for profit. Partnerships are pass-through entities, meaning the entity itself does not pay income tax.

Tax Treatment:

• Partnership files Form 1065 (informational return only)
• Each partner receives Schedule K-1 showing their share of income, deductions, and credits
• Partners report K-1 items on their individual returns
• General partners pay self-employment tax on their distributive share
• Limited partners generally do not pay SE tax on their distributive share

Key Characteristics:

• General partners have unlimited liability
• Limited partners have liability limited to their investment
• Partnership agreement governs profit/loss allocation
• Can have special allocations with substantial economic effect

S Corporation

An S corporation is a corporation that elects pass-through taxation under Subchapter S of the Internal Revenue Code.

Tax Treatment:

• Files Form 1120-S (informational return)
• Issues Schedule K-1 to shareholders
• No entity-level federal income tax (with some exceptions)
• Shareholders who work in the business must receive "reasonable compensation" (wages)
• Wages are subject to payroll taxes; remaining distributions are not

Eligibility Requirements:

• Maximum of 100 shareholders
• Only one class of stock (voting rights may differ)
• Shareholders must be U.S. citizens or residents, certain trusts, or estates
• No partnerships, corporations, or nonresident aliens as shareholders
• Cannot be a bank, insurance company, or domestic international sales corporation (DISC)

C Corporation

A C corporation is a regular corporation taxed under Subchapter C. It is a separate legal entity from its owners.

Tax Treatment:

• Pays federal income tax at a flat 21% rate (established by TCJA 2017, made permanent)
• Files Form 1120
• Double taxation: Corporation pays tax on profits; shareholders pay tax again on dividends received
• Qualified dividends taxed at preferential rates (0%, 15%, or 20%)
• Can retain earnings for business growth (accumulated earnings tax may apply if unreasonable)

Key Characteristics:

• Unlimited number of shareholders
• Can have multiple classes of stock
• Most flexible for raising capital
• Fringe benefits (health insurance, etc.) often fully deductible for owner-employees

Limited Liability Company (LLC)

An LLC provides liability protection similar to a corporation with flexible tax treatment.

Default Tax Classification:

• Single-member LLC: Disregarded entity (taxed as sole proprietorship)
• Multi-member LLC: Taxed as partnership
• Can elect to be taxed as S corporation or C corporation (Form 8832)

Pass-Through vs. Double Taxation Comparison

Schedule K-1: The Pass-Through Reporting Document

Schedule K-1 is the form used to report each owner's share of a pass-through entity's income, deductions, credits, and other items.

K-1 Sources:

• Schedule K-1 (Form 1065): Partnerships and multi-member LLCs
• Schedule K-1 (Form 1120-S): S corporations
• Schedule K-1 (Form 1041): Estates and trusts

Common K-1 Items:

• Ordinary business income or loss
• Rental real estate income or loss
• Interest and dividend income
• Capital gains and losses
• Section 179 deductions
• Charitable contributions
• Self-employment earnings (partnerships)

The Qualified Business Income (QBI) Deduction

The Section 199A deduction allows eligible taxpayers to deduct up to 20% of qualified business income from pass-through entities, sole proprietorships, and rental activities.

2025 QBI Thresholds

QBI Limitations for Higher Incomes

Above the threshold amounts, the deduction may be limited by:

1. W-2 Wage Limitation: Greater of:

   • 50% of W-2 wages paid by the business, OR
   • 25% of W-2 wages plus 2.5% of unadjusted basis of qualified property

2. Specified Service Trade or Business (SSTB) Limitation: Certain service businesses (health, law, accounting, consulting, athletics, financial services) face complete phase-out of the deduction at higher income levels.

QBI Deduction Calculation Example

Sarah operates a sole proprietorship with $150,000 of qualified business income. Her taxable income before the QBI deduction is $180,000 (single filer).

Since Sarah's income is below the $197,300 threshold, she can take the full 20% deduction:

• QBI Deduction = $150,000 x 20% = $30,000
• This reduces her taxable income to $150,000

Entity Selection: Tax Planning Considerations

When a Sole Proprietorship May Be Appropriate:

• Simple business with low liability risk
• Owner wants minimal administrative burden
• Annual profits are modest
• No plans to bring in partners or investors

When an S Corporation May Be Appropriate:

• Owner can save on self-employment tax through reasonable salary
• Business has consistent profits exceeding owner's salary needs
• Meets S corporation eligibility requirements
• Owner wants pass-through taxation with liability protection

When a C Corporation May Be Appropriate:

• Business plans to raise capital from outside investors
• Needs multiple classes of stock
• Wants to retain significant earnings for growth
• Owner-employees benefit from C corporation fringe benefits
• Planning eventual public offering

When a Partnership or LLC May Be Appropriate:

• Multiple owners with varying investment levels
• Desire for flexible profit/loss allocations
• Pass-through taxation preferred
• Liability protection needed (LLC)