Numerous designations for business formations exist at the state level, but only six business entities are recognized by the Internal Revenue Code (IRC) for federal tax purposes.
Partnerships file tax return Form 1065, and non-profit organizations must file Form 990 to maintain their tax-exempt status. Trusts are also considered a business entity, and they file Form 1041 for income tax purposes.
Estates might also have to file the Form 706 return, but this is for estate taxes, not income tax liability.
What About Limited Liability Companies?
Limited liability companies (LLCs) are not considered a distinctly separate business entity. An LLC can elect to be taxed as a sole proprietorship, as a partnership, as a C-corporation, or as an S-corporation. The owners of a limited liability company can choose which tax treatment will apply.
An LLC with just one owner is considered a disregarded entity by default. It's taxed the same way the owner of the LLC is taxed. An LLC with two or more owners is considered a partnership by default.
An LLC can opt out of the default treatment by electing to be treated as a corporation. Owners of an LLC can further elect to be treated as an S-corporation after electing to be treated as a corporation.
Sole proprietors are unincorporated businesses. They're also sometimes referred to as independent contractors, consultants, or freelancers.
It's not necessary to fill out registration forms or to officially elect to start this type of business. Simply complete Schedule C with your personal 1040 tax return. This is the easiest form of business to set up, and the easiest to dissolve.
A "single-member" LLC with only a single shareholder is taxed as a sole proprietor on a Schedule C.
Shareholders of C-corporations have limited liability protection, and corporations have full discretion over the amount of profits they distribute or retain. Corporations are presumed to be for-profit entities. They must have at least one shareholder. C-corps are taxed at the corporate level.
S-Corporations are a type of corporation. The shareholders of S-corporations have limited liability protection as well, and these corporations have full discretion over the amount of profits they can distribute or retain.
An S-corporation must have at least one shareholder, but it can't have more than 100 shareholders. The net income of an S-corporation is imputed as income to the shareholder, even if the S-corporation decides to retain some or all of its net income. It's known as a "pass-through" business entity.
A partnership is an unincorporated business, but like corporations, it's a separate entity from its shareholders or partners. Unlike corporations, partnerships must have at lease one general partner who assumes unlimited liability for the business.
Partnerships must have at least two partners. The net income of the partnership is imputed as income to the partners, even if the partnership decides to retain some or all of its net income.
Nonprofits are corporations formed for a charitable, civic, or artistic purpose. They're generally exempt from federal and state taxation on their incomes, so they're often referred to as "exempt organizations."
Nonprofits must nonetheless report their activities, income, and assets to ensure that they're in compliance with federal and state laws governing charities.
Trusts are formed by an individual prior to death, or they can be created upon death to transfer cash, investments, and assets to living beneficiaries. Some are immediately dissolved after these transfers occur. Others can remain up and operational to oversee and manage ongoing distributions and bequests.
Trusts must file a Form 1041 tax return if they have gross income of $600 or more for the tax year, or if any beneficiary is a nonresident alien.
The Qualified Business Income Deduction
The qualified business income (QBI) deduction is available to pass-through business entities—sole proprietorships, partnerships, and S-corporations—effective 2018. It was created under the terms of the Tax Cuts and Jobs Act (TCJA).
The QBI deduction allows these businesses to deduct 20% of their qualified business income. They can also deduct 20% of qualified publicly traded partnership income and 20% of qualified real estate investment trust income.
The exact rules are subject to some income limitations. The QBI deduction is not available to C-corporations.
The Bottom Line
Business considerations play a crucial role in deciding which form of organization is best for your enterprise. Consult with a professional to balance the tax benefits of incorporating against your various business and legal needs.