Question

Explain in writing the potential benefits and problems of electing to be taxed as a general partnership with respect to a comparison with corporate taxation and organization.

Answer 1

Explain in writing the potential benefits and problems of electing to be taxed as a general partnership with respect to a comparison with corporate taxation and organization.

Partnership Tax Rules

A partnership is a business structure where ownership and management responsibility of a company is split between two or more individuals. A partnership is not a legal entity that is separate from the owners and therefore the partnership itself does not pay taxes. The Internal Revenue Service says that under a partnership structure, the profits a business earns flow directly to the personal income tax returns of the owners. For example, if a partnership with two owners makes $500,000 in profit and the owners split profits equally, each would have to report $250,000 in income on their personal tax returns. Partners are responsible for paying self-employment taxes on business income.

Corporation Tax Rules

A corporation is a business that is owned by a group of shareholders who purchase stock in the company. A corporation is a legal entity that is separate from the owners for tax purposes. According to the IRS, the corporations pay income taxes on profits when they are earned. Unlike the owners of partnerships, shareholders are not responsible for paying taxes on the profits a corporation earns. Shareholders of corporations are not subject to self-employment taxes.

Entity-Level Taxation

A corporation is an independent legal entity that exists separately from its shareholders. It is considered a taxpayer by the Internal Revenue Service and must file an annual income tax return under its own name and employer identification number. The corporation pays taxes on net income at the corporate tax rate, unless it meets the requirements to be an S corporation, in which case it can pass through its earnings to shareholders and avoid double taxation. A partnership is not an independent legal entity and is not a taxpayer under IRS rules. Partnerships are business endeavors that operate under the legal names and personal responsibility of the partners. A partnership reports its revenue and expenses to the IRS annually on an informational tax return but does not pay taxes as a business entity.

Pass-Through Taxation

Instead of paying entity-level taxes, a partnership passes its profits and losses through to its partners on a proportional basis. Each partner reports his share of profits and losses on his individual income tax return and pays taxes on the amounts at his individual tax rate. This pass-through taxation is considered one of the primary benefits of operating a business as a partnership.

Double Taxation

Corporations distribute profits to shareholders as dividends. Dividends are disbursed from the corporation's after-tax profits on a per-share basis. Once a shareholder receives his dividend payment, he must report the payment on his personal income tax return and pay taxes on the distribution at the individual tax rate. This double taxation of corporate profits – once at the entity level and again at the shareholder level – is considered one of the major drawbacks of setting up a business as a corporation

Taxing Owner Payments or Benefits

Corporations and partnerships face different tax treatment relating to owners who work for the company. The IRS considers partners who work for a partnership to be self-employed and not employees of the business. Any compensation a partner takes for services rendered to the partnership is treated as an advance against profits. The partner must pay self-employment taxes on the money. Comparatively, shareholders who work for a corporation are considered employees of the business. They are paid wages from which the corporation deducts the employee's share of payroll withholdings while paying the employer's share. The corporation gets to write off employee salaries and payroll taxes as a business expense. Also, corporations typically cam deduct many types of fringe benefits paid to shareholders who work for a corporation as business expenses, while the IRS prevents partners from deducting many of the same expenses.