If you’re debating whether to open a business under a corporation or as a sole proprietor, your decision can significantly affect the amount of income tax you’ll pay on business profits. One of the main reasons is because the Internal Revenue Service treats corporations, commonly referred to as “C Corporations” or "C-Corps," as separate taxpayers that are subject to corporate tax rates. A sole proprietorship’s earnings, however, are taxed under individual tax rates – which are usually lower.
Sole Proprietor Taxes
When filing personal tax returns each year, sole proprietors must attach a Schedule C (or Schedule C-EZ) to their 1040 forms. The Schedule C separately reports your business income and expenses to arrive at the net amount that’s taxable. Once your net income is calculated, the amount is then reported on the “business income” line of your 1040 and is combined with all other income you earn that’s unrelated to your business, such as employment earnings and bank interest. As a result, the tax you’ll owe on sole proprietor earnings is calculated using the individual tax brackets.
As the shareholder of a corporation, the income taxes due on business earnings are completely separate from your personal taxes and are reported on Form 1120, the corporate tax return form. The corporation will have its own employer identification number (EIN) which is reported on Form 1120, along with the corporation’s legal name. Moreover, the corporate entity is responsible for remitting all tax payments to the IRS, though as the sole shareholder, you will likely take responsibility for these tasks. And although the amount of taxable business income reported on the 1120 would be the same as the amount reported on a Schedule C in most cases, there will be a difference in the amount of tax owed because of the corporate tax rates that apply.
Tax Rate Differences
Both the corporate and individual tax brackets are progressive, meaning that different portions of business income are taxed at different rates. Because the corporate tax rates are higher than individual rates, the corporation will owe more tax on business earnings than if you reported the same amount of earnings on a Schedule C. Also relevant is the fact that you can further reduce the amount of income subject to tax on your personal return by itemizing, taking the standard deduction and claiming personal and dependent exemptions – none of which are available on corporate tax returns.
A higher rate of tax isn’t the only disadvantage of using a corporation -- there is also the double taxation issue to be aware of. After a C-Corp pays the income tax it owes, only then can you withdraw some of the after-tax earnings for personal use. When you do, the IRS treats the withdrawal as a dividend that you will have to report on your personal tax return and pay tax on. This means that more of your business earnings are going towards tax payments when using a corporation.