Basic Tax Rules: Partnerships, C Corp, and S Corp

The purpose of this article is to review the basic tax laws governing various forms of business. The forms of business that will be discussed are general partnerships, C corporations, and S corporations.

General Partnership

General partnerships are flow-through entities. This means that the partnership itself does not pay any income tax. Instead, each partner is taxed on the net profits of the business. The partnership must file an information return, Form 1065, U.S. Return of Partnership Income, and business profits are reported as self-employment income on Form 1040, Schedule C, Profit or loss from Business or on Form 1040, Schedule C-EZ, Net Profit from Business).

In addition to income tax on the profits, each partner must pay self-employment tax up to the FICA limit. Self employment tax is reported on Form 1040, Schedule SE, Self Employment Tax. The self-employment tax rate for 2006 is 15.3%, which is broken down into two parts: 12.4% for Social Security and 2.9% for Medicare. Self-employment tax is only applied to "the first $94,200 of...combined wages, tips, and net earnings in 2006" (Self Employment Tax). Self-employed individuals who do not have taxes withheld must make estimated tax payments, which are due quarterly. Estimated tax is determined by figuring "expected adjusted gross income, taxable income, taxes, deductions, and credits for the year" (Estimated Taxes).

C Corporation

C corporations are not flow-through entities. The C corporation form of entity results in double-taxation. First, the C corporation is taxed as a separate entity using corporate income tax rates: the first $50,000 at 15%, the next $25,000 at 25%, and additional profits up to 35%. The C corporation must report income using Form 1120, U.S. Corporation Income Tax Return or Form 1120A U.S. Corporation Short-Form Income Tax Return. Second, any dividends paid to stockholders are taxed again at the stockholders' tax rates, and each of the stockholders must report this income on their year end individual income tax returns.

S Corporation

"Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income" (S Corporations). S corporations are flow through entities, because each shareholder's individual tax return will report the income or loss generated by the S corporation. S corporation shareholders are taxed based on their pro-rata share of corporate income, regardless of whether the corporation actually distributes the income to its shareholders.

If the S corporation does owe income tax, it must be reported on Form 1120S, U.S. Income Tax Return for an S Corporation. Shareholders will report income using Form 1040, Schedule E, Supplemental Income and Loss, and self employment tax is reported on Form 1040, Schedule SE, Self Employment Tax.

References

"Estimated Taxes." IRS website. URL: http://www.irs.gov/businesses/small/article/0,,id=110413,00.html

"S Corporations." IRS website. URL: http://www.irs.gov/businesses/small/article/0,,id=98263,00.html

"Self-Employment Tax." IRS website. URL: http://www.irs.gov/businesses/small/international/article/0,,id=105255,00.html