Thomas G. Post
"The Texas Tax Man"
Certified Public Accountant
Home | Sales Tax | Payroll | Entrepreneurs | Sole Proprietors

1305 Keefer, Suite 103
Tomball, TX 77375
P O Box 1757
Tomball, TX 77377-1757
Phone: 281-351-2688
Fax: 281-351-2694
tpost@texastaxman.com
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(Forms of Business Overview)

Entrepreneurship is the process of bringing together resources and people to make things happen for a profit.

For purposes of this discussion, there are three types of compensation in connection with entrepreneurship:

1. Service
2. Operating
3. Goodwill

SOLE PROPRIETORSHIPS

The simplest form of business is a sole proprietorship. In this form, the owner does not receive a salary so there is no distinction between service and operating profits. The net income of the business is subject to both income tax and self-employment tax each year. If the business is sold, the owner/operator can realize a profit from developed goodwill that is subject to capital gain income tax rates and not subject to self-employment tax rates.

PARTNERSHIPS (& LLC’S)

In its’ most simple form, a partnership is two sole proprietors joined together to share profits and losses equally. Although partners do not receive salaries, as such, there is a distinction between payments for services and operating profit. Payments for services are called guaranteed payments. The remainder of profits after payments to partners for services rendered is divided amongst the partners based on their ownership share.

Guaranteed payments are always subject to self-employment tax. Operating profits are subject to self-employment tax for general partners. Limited partners are not subject to self-employment tax on operating profits in excess of payments for services. LLC’S (Limited Liability Companies’) members are usually considered limited partners for this purpose.

Generally speaking, whenever all the owners of an entity are protected from corporate liabilities; the entity will be subject to state franchise tax. In Texas, this amounts to a four and one half percent state income tax on operating profit.

In a partnership both service and operating profits are taxable income to the owners. A partner can realize a profit from developed goodwill at favorable capital gains rates by selling his/her partnership interest (where permitted).

S-CORPORATIONS

An S-Corporation is an incorporated entity that has elected to be taxed as a "flow through" entity similar to the manner in which partnerships report their income. In any corporation, compensation for services must be handled as payroll. Thus, self-employment tax does not apply, but the employer must pay one-half of social security and Medicare taxes; and must withhold one-half from the employee. Unemployment taxes (federal and state) also apply to this compensation. Operating profits allocated to the shareholders are not subject to self-employment tax. This type of entity is also subject to state franchise taxes.

Shareholders of an S-Corporation (2% or more) are not entitled to the following employee fringe benefits:

1. Accident and health insurance
2. Cafeteria plans
3. Group-term life insurance
4. Meals and lodging for the convenience of the employer

In S-Corporations, both service and operating income profits are income taxable to the shareholders. A shareholder can realize a profit from developed goodwill at favorable capital gains rates by selling his/her shares.

C-CORPORATIONS

A C-Corporation is a regular corporation that has not made an election to be taxed as a "flow through" entity. The first $50,000.00 of corporate earnings is taxed at the fifteen percent rate. Corporations that retain profits for expansion should remain a C- Corporation and pay tax at a lower rate.

Shareholders of a C-Corporation are entitled to the following employee fringe benefits:

1. Accident and health insurance
2. Cafeteria plans
3. Group term life insurance
4. Meals and lodging for the convenience of the employer

As with the S-Corporation, compensation for services must be handled as payroll.

There is substantial parity between the entities discussed here regarding profit sharing plans. A profit sharing or 401(K) plan can be used to reduce corporate taxable income without imposing individual tax on the employees benefiting from the plan.

In a C-Corporation operating profits are taxable to the corporation not the shareholders. A shareholder can realize a profit from developed goodwill at favorable capital gains rates by selling his/her shares.

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