Ahh, it’s tax season. As Albert Einstein once said, “The hardest thing in the world to understand is the income tax.” But Benjamin Franklin once said, “In this world nothing can be said to be certain, except death and taxes.”
For small business owners, taxes are the only annual certainty in business. So now, it’s time once again to try to understand that ever-changing U.S. tax code. Adding to the complexity of understanding the tax code, politicians continue to fuel the fire with cries to amend it, debating what Americans are obliged to pay. In January, the Obama Administration proposed reform focusing on cuts to the corporate rate without lowering rates for businesses that pay tax through their owners’ individual filings.
Today, small business owners often pay taxes through individual filings to take advantage of lower tax rates or to avoid the added regulatory scrutiny that corporations face. Many small businesses say cuts would be unfair to millions of small firms that pay income tax rates as high as 39.6 percent when filing via their owners’ individual returns.
With changing amendments, loop holes, provisions, breaks, inclusions, exclusions, addendums and regulations, entrepreneurs would need an army of full-time attorneys and accountants to identify every tax break in the 75,000+ pages of the tax code.
And while the tax code begins at the federal government level, it doesn’t end until it tax obligations are paid at the state level and finally, your local city hall. According to the Small Business and Entrepreneurship Council, most taxes have been increased over recent years, including capital gains tax, dividend tax, death tax, payroll tax and personal income tax—which the majority of businesses pay rather than corporate income tax.
Why you may ask? Federal corporate tax rates in the U.S. have been increasing. Today, most small businesses and entrepreneurs are filing business earnings in personal income tax code rather than corporate income tax code, such as sole proprietorships, partnerships, LLCs and S-corporations.
If you’re starting a business, you should determine the best business structure for your plans today and tomorrow. If you’re running a small business that is growing, review your current structure and make sure you’re set up for growth. Determining the most appropriate structure will depend on many factors, including ownership, liability, the legal structure, planned growth and more. Here’s a quick overview of business structures, including legal responsibilities and tax implications.
First, without filing to establish a business structure, you operate as a sole proprietorship. You do not pay federal business income tax and your earnings are taxed on your personal income. You report your earnings and expenses from your business on Schedule C or C-EZ, and attach the schedule to your Form 1040 when you file your personal income tax return. With this structure, you have full liability for business debts. Let’s cut to the chase here. This means that if someone sues you related to your business, not only your business assets but also your personal assets are up for grabs.
Forming a partnership is less complex than incorporating, and less expensive. For most states, you need to draft a partnership agreement and register with your state. Partnerships have to file a Form 1065 with the IRS to report their earnings and payments to partners, and do not pay income taxes. Instead, they issue each partner a Schedule K-1. The partners include the earnings shown on the K-1 with their personal income tax report.
Options for Incorporating Your Business
Think protection of your personal assets against business liabilities and debts. With this protection, you will face more complexity in taxes as you will pay taxes on business profits. Your salary and distributions will be included in your personal income taxes. Here are your options:
Limited Liability Corporation (LLC)
Not a separate tax entity as these entities are regulated state-by-state, LLCs provide no tax advantages and serves as a pass-through for owners income to tax in personal taxes. Yet with an LLC, you receive most of the personal asset protection of a corporation without the complexity. LLCs are taxed similarly to sole proprietorships or partnerships, depending on ownership.
- Single owner-LLCs report all profits and losses on a Schedule C with the 1040 tax return.
- In multi-owner LLCs, owners each pay taxes on their share of the profits on their personal income tax returns with the Schedule E form. The percentage of tax implications should be defined in the business operating agreement. Other tax filings include Form 1065 with the IRS. A Schedule K-1 is required from the LLC, breaking down each member’s share of the LLC’s profits and losses.
- Be sure to research LLC regulations in your state to determine any additional state taxes.
S Corps provide some tax savings as profits are not included in self-employment taxes. Before any profits are distributed, the owner-employees must be paid a reasonable salary, which is subject to Social Security and Medicare taxes. An S Corporation files a tax return but the profit or loss passes through via a Schedule K-1 to the individual income tax return. The tax liability and the taxes are assessed and paid by individuals. The maximum tax rate is 39.6%. S Corp losses are applied to other income to reduce the tax liability of the shareholder and some are subject to state tax liability and therefore estimated tax payment depending upon the rules is required. Each shareholder who receives a K-1 must factor in the profit or loss in determining the amount of estimated tax payments to be paid at the individual level. Clearly, compared to the LLC, taxes become more complicated.
The C Corp is taxed on its income rather than a pass through. Profits are taxed when earned and taxed again when distributed, often called “double taxation.” Shareholders cannot deduct any corporate losses. Owners cannot arbitrarily draw funds and must pay estimated tax payments based on the profit. Using this structure, the entity files a standalone tax return and pays taxes at the corporate level. Losses may be carried forward or backward. The maximum tax rate for a corporation is currently 35%.
If your organization is involved primarily in educational, scientific, religious or charitable endeavors, you’ll likely want to form a nonprofit corporation for the liability protections and tax advantages this status provides. You get the same legal protection as the other corporations from liability of personal assets, eligibility for public and private grants, and can seek tax-exempt status with a IRS 501(c)(3) to file Form 1023. Several states also require organizations to file for state-level tax-exemption. Donations are tax-deductible to these entities.
In the end, it’s important to understand how to structure your business as it impacts taxation, liability and growth. Consult with your accountant or attorney to determine what is best for your business. For more information, go to the IRS Publication 334: Tax Guide For Small Business.