C corporations -- corporations that have not elected to be taxed under Subchapter S of the Internal Revenue Code -- enjoy two main advantages over partnerships and sole proprietorships: limited liability and corporate taxation. Limited liability is the main reason that most businesses choose to incorporate. However, the IRS treats corporations differently from partnerships and sole proprietorships for the purposes of both income tax and self-employment tax, often resulting in a net tax savings for shareholders.
General partners and sole proprietors can be sued in their personal capacity for debts incurred by their business. The financial risk of corporate shareholders, on the other hand, is limited to the value of their shares, because corporate creditors cannot sue a shareholder for corporate debts. Certain exceptions exist, however. For example, a corporate shareholder who takes an active role in running the corporation can be sued for his own wrongful acts. One example of this might be if he is on duty, driving a company car and causes an accident under the influence of alcohol.
Self-employment tax is meant to be a substitute for the payroll taxes paid by employees. Sole proprietors and general partners must pay self-employment tax on their share of the net earnings of the business. The payroll tax varies from year to year, but at the time of publication the rate was 13.3 percent of the first $106,800 in net earnings, and 2.9 percent of any amount exceeding $106,800. General partners and sole proprietors pay self-employment tax, but corporate shareholders do not.
Partnerships and sole proprietorships do not pay income tax to the IRS. However, the owners must pay income tax on their proportionate share of the taxable income received by the business during the tax year, even if this income is re-invested in the business instead of distributed to the owners. This is known as "flow-through" taxation. Shareholders in C corporations, by contrast, are taxed only on dividends they actually receive from the corporation. Income received by C corporations is also taxed at the corporate level; however, since corporate income tax rates are generally lower than individual income tax rates, a C corporation's ability to shield income from individual income taxation by retaining it rather than distributing it to shareholders can result in a net tax savings under many circumstances.
One of the consequences of flow-through taxation is that a partner can be assessed a large tax bill on reinvested partnership income. If the reinvested income does not generate much income during the tax year, a partner might be left without the means to pay the tax. Because of this, a majority of wealthy partners can vote to reinvest partnership income over the objections of a minority partner who can't afford to pay the income tax liability unless the income is distributed rather than reinvested. This technique is sometimes used to "squeeze out" an unpopular partner. Because C corporation shareholders are taxed only on dividends they actually receive, they are not vulnerable to squeeze-outs.
David Carnes has been a full-time writer since 1998 and has published two full-length novels. He spends much of his time in various Asian countries and is fluent in Mandarin Chinese. He earned a Juris Doctorate from the University of Kentucky College of Law.