An important part of running any business is settling its federal tax responsibilities. The choice of business organization significantly influences how the business is taxed and how much it may have to pay. A corporation is an entity in which the owners are generally not personally liable for the business’s obligations. A partnership is a collection of individuals that come together, in which some of the partners are personally liable for the business’s obligations. As a result, these entities are taxed differently and have different IRS filing requirements.
Legal Entity vs. Disregarded Entity
The biggest difference between a corporation and a partnership is who pays taxes on the business income. A corporation is considered a separate legal entity for tax purposes, which means that it must pay annual taxes on the income it receives based on the corporate tax rate. It does this by filing Form 1120 under its Employer Identification Number. On the other hand, a partnership does not pay taxes on the income it receives, although it still must file a Form 1065 with the IRS, disclosing its financial activity for the year. The partnership is considered a disregarded entity. Therefore, business income and loss is divided amongst the partners, and each includes those balances on their personal returns. Each partner then pays tax on the income based on their personal tax rate.
Read More: What Is a Disregarded Entity LLC?
When a corporation distributes some of its income to its shareholders, the shareholders generally must pay tax on what it receives. This is why corporations are said to be “double taxed” -- the corporation pays tax on the money when it is earned and then when it distributes this taxed income to its owner, tax must be paid on it again. In comparison, when a partnership distributes income, the recipients generally do not pay any tax on what it received. The partnership keeps track of each partner’s investment in the business. The partner only has to pay tax if the amount of money distributed by the partnership exceeds his investment balance.
Sometimes owners of a business perform work for their enterprise. If a partner works for his partnership, he is not considered an employee. Instead, he is required to pay self-employment tax on his share of the partnership’s earnings. The self-employment tax helps fund Social Security and other federal entitlements. If a shareholder works for his corporation, he is considered an employee. The shareholder pays for half of his employment tax obligations and the corporation pays the other half.
1099-DIV and K-1s
If a corporation issues a dividend, at the end of its tax year it must issue a 1099-DIV to its shareholders and the IRS. This form details what each shareholder received in dividends. A partnership is required to issue Form K-1s to its partners and the IRS. This form details each partner’s share of the business’s financial activity. The partners use this form to determine what they need to include in terms of revenue on their personal tax return.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.