When it comes to the US tax code, very little seems simple and straightforward—even the definition of a business.
There are several federal tax classification options, and it’s helpful to understand the rules and implications of each category. A classification is a major factor in determining how much your business—and you personally—might owe in a tax year.
What follows will help you understand the various classifications and their tax implications.
What is federal tax classification?
The Internal Revenue Service (IRS) has six primary ways a business can be classified for tax purposes: sole proprietorship, partnership, C corporation, S corporation, limited liability company (LLC), and nonprofit. Each classification has specific definitions and restrictions that determine how the business operates and how it’s taxed.
As a business owner, choosing which classification is best depends on the size, scale, and scope of the company. The main difference between corporate entities and non-corporate entities is the separation of the business from the owners (or shareholders or members): in corporations and LLCs, the owners or shareholders are legally separate from the business; in a sole proprietorship, they are not.
6 types of tax classifications for businesses
Businesses generally fall into six different classifications for tax purposes, including:
1. Sole proprietorship
Asole proprietorshipis a business owned and operated by one individual. For federal tax purposes, sole proprietorships aren’t considered separate from the owner—the business and the owner are legally the same entity. This means the owner’s personal assets can be targeted in the event of bankruptcy or legal action taken against the owner.
Sole proprietorships are pass-through entities: The company’s profits (or losses) are passed through to the business’s owners or shareholders as income to report on their personal tax returns. They then pay tax based on their individual income tax rates. However, because sole proprietors are considered self-employed, they must pay additional self-employment taxes that cover both the employee- and employer-paid portions of Medicare and Social Security taxes.
A single-member limited liability company (LLC) also is considered a sole proprietorship for tax purposes.
Pros of sole proprietorships
- Setup and operation are simple.Although rules may vary from state to state, becoming a sole proprietor is simple—typically with little to no paperwork.
- Less complex tax filing.Sole proprietorships aren’t separate from their owners, so the business’s income is simply treated like an individual's personal income. Other business classifications, such as C corporations or S corporations, may be subject to more complex tax laws and rules about their structure.
- No double taxation.Some companies, mainly C corporations, are a separate business entity from their owners or shareholders for tax purposes. These businesses pay corporate tax rates on earnings, while profits distributed to owners are taxed at their individual income tax rates. This is known as double taxation. Sole proprietorships avoid this.
独资企业的缺点
- Personal liability.You aren’t shielded from the business’s debts and liabilities: Your personal assets may be at stake in litigation or should the business file for bankruptcy.
- Limited ability to raise capital.Unlike a corporation, sole proprietorships can’t issue stock or bonds to raise money for business expansion. Instead they have to rely mostly on reinvesting profits back into the business, or borrowing.
- Subject to self-employment taxes.When someone is a full-time employee of a larger company, the employer pays half an employees’ Social Security and Medicare taxes, also known asFICA taxes. As a sole proprietor, you’re self-employed, so you must pay it all asself-employment tax, which as of 2023 was 15.3% of income.
Learn the nexus conditions for each state
Shopify has a helpful sales tax reference page for learning the sales tax rates, collection rules, and nexus conditions for each state.
See nexus conditions2. Partnership
Your business is apartnershipif it’s owned by two or more individuals who also share the responsibility for management of the business as well as any profits and losses.
For tax purposes, the business’s profits pass through to the partners—who report the proceeds on their personal income tax returns. They’ll pay federal taxes at their individual income tax rates, typically including self-employment taxes.
There are three main types of partnerships:
- General partnerships, in which partners equally share management responsibility as well as any income or losses the business generates.
- Limited partnerships, which let outside investors buy into a business while limiting their liability and involvement based on their contributions. This is a more complicated, yet more flexible, form of partnership.
- 乔int ventures, which often are short-term projects among multiple partners. (If the venture performs well, it may continue as a general partnership, and if it doesn’t, the venture can be more easily shuttered.)
Pros of partnerships
- Fewer regulations.This structure isn’t subject to the complex tax laws and other regulations that apply to corporations.
- No double taxation.Partnerships are pass-through entities, also called disregarded entities, which means the business doesn’t pay tax on its profits. Instead, the profits pass to the partners, who pay income tax at their personal rates.
- Shared responsibility in equal partnerships.一般装备之间的伙伴关系的本质al partners provides you with the shared joys and pains of management, including the work and the decision-making it takes to run a business.
Cons of partnerships
- Personal liability.Unless your partnership is set up as an LLC, the personal assets of the partners could be at risk if the business is sued, declares bankruptcy, or faces other liabilities.
- Difficult to manage disputes in general partnerships.In partnerships set up with each owner as an equal partner, resolving disagreements about the business may prove difficult or impossible.
3. C corporation
AC公司, or just corporation, pays corporate income tax because it’s separate from its owners and shareholders. Owners or shareholders also must pay tax on any distributions of profits at their personal tax rates. C corporation owners don’t pay self-employment taxes, but if they receive a salary, this amount is subject to payroll taxes.
A C corp is the business structure and tax classification most commonly used by major companies, but some small-business owners can choose to take advantage of the benefits as well—such as issuing stock to raise capital. An investor who buys stock holds a fractional interest in the company, reducing an owner’s stake in the business.
Pros of C corporations
- Limited personal liability.C公司s shield owners and shareholders from business liabilities and debt. Only business assets are at risk in litigation or bankruptcy, not the owners’ personal assets.
- Ability to issue stock to raise capital.C公司s can sell stock in the company to raise money for expansion, avoiding the need to take on debt.
- Unlimited shareholders.Unlike another corporate form called S corp, which must follow strict rules related to their structure and operation, C corps can have as many shareholders as they like and issue different types of stock.
Cons of C corporations
- Complex rules and regulations.Understanding corporate tax law often calls for specialized knowledge, and the legal structure imposes requirements such as an annual shareholder meeting, company bylaws, and financial disclosures.
- Double taxation.C公司s must pay corporate tax rates on earnings, while profits or dividends distributed to owners or shareholders are taxed at their individual income tax rates.
- Expensive to establish.Compared with simpler structures such as LLCs and sole proprietorships, C corporations are legally complex. Creating them typically requires hiring tax professionals and lawyers.
4. S corporation
S corporationsare both a business entity class and a tax structure available to other private entities, such as LLCs and partnerships. S corporations are considered legally separate from their owners, but they generally don’t pay corporate income tax.
This avoids the double taxation issue: Any profits or losses pass through to the owners or shareholders, who would pay income tax at their individual rates. Additionally, if owners of an S corp pay themselves a salary, they are subject to payroll taxes on those wages.
To qualify as an S corp, your business must be a domestic company operating in the US, and all shareholders must be US citizens or permanent residents. An S corp can have no more than 100 shareholders, and those shareholders must be actual people—not other corporations, partnerships, or investment funds. They must have boards of directors, hold annual meetings, and adhere to company bylaws.
Certain industries, such as banks, insurance agencies, and import-export companies cannot be S corps. Plus, some states and cities—such as New York—don’t recognize S corps and instead treat them as C corps for tax purposes, which means an S corp and its owner would pay double taxes at the local level.
Pros of S corporations
- Limited personal liability.Like a C corp, the business and its owners are considered separate entities, so only the business’s assets are subject to creditor claims or litigation.
- No double taxation.The company itself doesn’t pay corporate income tax; instead, the business’s income is reported on the owner’s individual tax return and is subject to self-employment tax.
Cons of S corporations
- Complex tax rules.Corporate tax regulations can be complicated, and compliance often requires specialized knowledge and professional advice. S corps are particularly closely watched by the IRS, because they include certain favorable tax breaks. For example, an employee-shareholder’s wages are considered distributions subject to personal income tax, but not self-employment tax.
- IRS requirements may be limiting.TheIRSrules for S corps limit this classification to businesses with US domestic incorporation, only one class of stock, and no more than 100 shareholders.
- One class of stock.S corps are permitted to issue only one single class of stock, unlike C corps, which can sell both common and preferred stock.
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Explore Shopify Tax5. Limited liability company
Alimited liability companyis a structure commonly used by US small business owners, whether with one owner (single-member LLC) or several (multi-member LLC).
From a legal perspective, LLCs ensure owners’ personal assets are insulated from business debts, lawsuits, and other liabilities.
LLC taxation typically depends on their structure. For a single-member LLC, the default tax designation is as a sole proprietor; for multi-member LLCs, the default designation is as a general partnership.
But if LLCs qualify for the rules of corporations, they can choose to be taxed that way. They may petition the IRS to receive a C corporation or S corporation tax classification by filingspecifictaxforms.
Here are four of the most common types of LLC tax classifications:
- Sole proprietorship.This category is for single-member LLCs only. In sole proprietorships, the business and the owner are not considered separate entities: The business’s profits or losses pass through to the owner, who pays income tax at their personal rates (along with self-employment tax).
- Partnership.This is only for multi-member LLCs, and it’s another pass-through entity: The business’s profits are reported on each partner’s individual tax return, and each pays personal income tax on their disbursement.
- C公司.This can be a single-member LLC, or a multi-member one. The business is considered a separate entity, so the company pays corporate income tax on profits. Any disbursement of profits to the LLC members are subject to taxation again, this time at individual income tax rates. C corp LLC members don’t have to pay self-employment taxes, but if they draw a salary they’ll remit payroll taxes for Social Security and Medicare.
- S corporation.. This may be a single- or multi-member LLC. S corps are considered separate entities from their owners, but the business doesn’t pay corporate income tax. Instead the business’s profits pass through to the owner or owners as income, and the owners pay individual income tax (although not self-employment tax). Additionally, if owners of an S corp receive a salary, they’ll pay payroll taxes on those wages.
See the sections above for additional details, as well as pros and cons, of each of these tax classifications.
6. Nonprofit
Nonprofitsare businesses that have been granted tax-exempt status by the IRS, with the reasoning that they are beneficial to society. Churches, public schools, legal-aid societies, public health clinics, museums, and research institutes are examples of nonprofits. They maximize revenue to supply funds for the causes they support, which differentiates them from other tax-exempt organizations that generate revenue simply to pay overhead.
Under this designation, an organization does not pay corporate income tax—though they typically must pay employment taxes for wages paid to staff. On the state level, some nonprofits enjoy even more benefits, such as exemption from paying sales tax on products and services purchased for business use.
To receive this tax-exempt status, an organization must file with the IRS to be recognized as a nonprofit. Once registered as a nonprofit, they must follow state-level charity rules, as well as IRS regulations: promoting welfare, typically avoiding political involvement, adhering to their core mission, and paying all staff fair wages.
Pros of nonprofits
- Federal income tax exemption.This is the chief benefit of forming a nonprofit: The organization doesn’t pay federal income tax to the IRS.
- Potentially limited liability.If a nonprofit is formed as an LLC, its directors and members avoid personal liability for the organization’s debts or legal obligations from lawsuits.
- Possible access to grant funding.Both public and private grants are available to help fund the operations of nonprofits (although some funding is limited to only certain types of nonprofits).
- 筹款。Nonprofits can also obtain operating funds from donations made by individuals or corporations that may make the gift as a federally tax-deductible item, depending on the type of nonprofit.
Cons of nonprofits
- Complex rules.To become a nonprofit, an organization must file articles of incorporation, draft and adopt bylaws, file for federal tax exemption, hold annual meetings, elect officers, register as a charity with a state authority, and more.
- Variance in state law.Though some state rules are beneficial for nonprofits, keeping track of the differences in exemptions can be cumbersome. For example, some states exempt nonprofits from paying sales or property taxes on donations, while others don’t. And a nonprofit in Florida that purchases office supplies may be exempt from paying sales tax on them, while a nonprofit in California is not exempt from paying sales tax.
What to consider about tax classification for your business
Tax classification has a major effect on your business’s tax liability, as well as your own personal tax returns. As you consider different structures, ask yourself:
- How many people have an ownership stake in my business and are involved in its operation?
- Do you want the option of issuing stock or debt to raise capital for the business? How much personal liability are you willing to tolerate?
- Do you have the funds and the wherewithal to hire tax professionals and lawyers to help create a more complicated structure such as a corporation?
Note that as an ecommerce business owner, your company may grow and change over time, so the classification that fits you best might also change. Regularly reviewing and updating your classification, if necessary, can help ensure compliance.
Federal tax classification FAQ
Can I change my federal tax classifications?
Yes, though the process depends on your company’s current classification, and which classification you seek. For example, for a partnership to become a corporation, you may need to file the appropriate paperwork, issue stock, and set up annual shareholder meetings. Changing your business’s tax classification may also change the way your company is taxed, as well as your personal tax liability, and you’ll likely need to file an entity < ahref="https://www.irs.gov/forms-pubs/about-form-8832" target="_blank">classification election form with the IRS.
Can a business have multiple tax classifications?
Yes. A business organized as a corporation for federal tax purposes may also be considered a partnership for state tax purposes. For example, some companies may also opt for different tax classifications for different parts of their business.
Do different classifications change the amount of taxes I owe?
Yes. Sole proprietorship and partnership pass profits through to owners to report on a personal income tax return—and that income typically will be subject to self-employment tax. C corporations, by contrast, are considered separate from the owners. The company pays corporate income tax on profits, while owners and shareholders pay regular income tax on any profit distributions. Lastly, S corporations are considered separate entities, but they’re also pass-through entities and the owners must treat any business profit as personal income for tax purposes.