Tax Classification of Businesses

Different types of business structures are classified for tax purposes by various letters or acronyms:  Schedule C, C Corporation, S Corporation, Schedule K-1, GP, LP, LLP, and LLC.

The simplest structure is a sole proprietorship:  a business owned directly by an individual, without using any partnership, corporation or other legal entity.  Income and expenses from a sole proprietorship are reported on Schedule C of Form 1040.

If that business is contributed to a new corporation, the tax rules are set forth in Subchapter C of Chapter 1 of the Internal Revenue Code, beginning at section 301 – in short, a “C Corporation“.  The advantages of being a C Corporation is that there can be an unlimited number of U.S and foreign shareholders, holding either common stock or various classes of preferred stock.  Nearly all publicly traded companies are C Corporations.  The main disadvantage is that the income of a C corporation is taxed twice:  once when earned, and a second time when distributed as a dividend to its shareholders.  But if the C corporation has a taxable loss, that does not benefit its shareholders.

For simple, small corporations, Subchapter S allows a more favorable structure.  The income of an S Corporation is passed through to its shareholders, so it is taxed only once for Federal purposes.  Because income is divided up equally for each share, only common stock is permitted.  Shareholders must be U.S. citizens or legal residents, and the number of shareholders is limited. Losses can also be passed through, subject to limitations.  Each initial shareholder must agree to elect S corporation status, generally within 75 days after incorporation, or by March 15 of a later taxable year.  Converting from a C Corporation to an S Corporation is possible, but can incur additional taxes in future years.  An S Corporation can borrow money, but the tax treatment is more favorable if the shareholders borrow money and contribute or loan those proceeds to the S Corporation.

A Partnership similarly passes through its income to the partners, so that income is taxed only once for Federal purposes.  Because tax rules for partnerships are in Subchapter K, that letter is sometimes used generally to refer to the partnership tax regime.  Perhaps coincidentally, the IRS form on which income is reported to partners is Schedule K-1.  Curiously, Schedule K-1 is also used by S Corporations for the same purpose.

Tax rules for partnerships are more complicated than for S Corporations.  For example, partnership interests can receive disproportionate allocations of income, loss, and distributions – unlike the equal treatment of each S Corporation share.  A partnership can borrow money in tax-advantaged ways.  Contributing property to a partnership, and receiving distributions from the partnership, are generally more favorable, and definitely more complex, than for an S Corporation.  Partnerships are better for holding assets that could appreciate, like real estate.  Of course, these are just some of the most notable differences.

State laws create several subtypes of partnerships that vary in imposing personal liability upon partners.  A General Partnership or GP can be formed by a handshake or an email, but provides no liability protection for any partner.  In a Limited Partnership or LP, there must be at least one general partner with full liability, while limiting the liability and the roles of the limited partners.  A Limited Liability Partnership or LLP provides special rules for professional services firms.

Finally, there is a chameleon:  the Limited Liability Company or LLC.  Depending upon its check-the-box election of tax status, an LLC can serve as any of the above alphabet entities.  If owned by a single individual, it can be disregarded and treated as a Schedule C sole proprietorship.  If owned by a single entity, an LLC is likewise disregarded and treated as a division of that entity for Federal income tax purposes.  If it so elects, an LLC with one or more owners can be a C Corporation  or (if eligible) an S Corporation.  Generally, an LLC with two or more owners is taxed as a partnership on Schedule K.

Of course, this simplified overview does not address all key differences (tax and non-tax) among business structures.  For instance, additional California taxes apply to an LP, an LLP, an LLC, and an S Corporation.  In selecting a type of entity for a particular business or investment activity, you and your professional advisors should consider Federal tax, California tax, personal liability, among other factors.

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