When starting up a new business, entrepreneurs need to decide what legal form the company will take and how it will report for tax purposes. Sometimes the legal form chosen dictates a direction to take with the tax decision, but some small business owners can choose to report as a corporation for tax purposes even if they choose a different legal form for the enterprise. A new report from the Small Business Association sheds some light on the financial ramifications of this decision.
The report, issued by Quantria Strategies of Cheverly, Md., under contract to the SBA, said that sole proprietorships pay taxes at the lowest average effective rate, 13.3 percent. In comparison, small business partnerships have an average effective tax rate of 23.6 percent, while S corporations’ average effective tax rate is 26.9 percent, according to Quantria’s study of IRS data from 2004.
Small businesses that are organized as S corporations, partnerships, and limited liability companies can choose to report for tax purposes as though they were organized as C corporations. According to the study, small businesses that report for tax purposes as C corporations pay taxes at an effective rate of 17.5 percent.
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The report noted that figuring the effective tax rate for C corporations is conceptually different from the calculation for the other entity types. C corporations are allowed to pay their owners salaries that are deductible from the company’s gross receipts before its taxable income is calculated, and the owners pay taxes on their salaries at the individual level. In comparison, compensation for owners of other businesses is reported as business profits on Form 1040, as figured on Schedule C for sole proprietorships and Schedule E for partnerships, limited liability companies, and S corporations. The consulting company carried out a microsimulation, calculating an effective tax rate at the entity level for each company that doesn’t pay taxes directly.
Variations by business size, industry
Some of the variation in effective tax rate is a function of the size of the businesses reporting in each entity type. For example, sole proprietorships make up 84 percent of businesses with gross receipts under $25,000, which would tend to bring their average effective tax rate down. Partnerships and S corporations, with approximately double the average effective tax rate of sole proprietorships, together make up a third of all small businesses with gross receipts between $100,000 and $250,000.
The report said that the effective tax rates by industry group vary little among partnerships and S corporations, but there is disparity for sole proprietorships and C corporations. For example, the rate for sole proprietorships ranges from 4.1 percent for utility companies to 14.2 percent for companies in wholesale and retail trade. Among C corporations, it ranges from 12.9 percent for agriculture to 27.1 percent for utilities.
The report noted that some variation in tax rates according to industry can be attributed to special tax provisions applicable to small businesses operating in that field. These include incentives for small producers of alternative fuels like ethanol and agri-biodiesel and tax breaks for small insurance companies.