January 19, 2022 | Small Business | by Blaine Thiederman MBA, CFP
Understanding the tax consequences and reporting requirements of different business entities is crucial for entrepreneurs. Here’s a breakdown of what you need to know.
- Individual-owned businesses default to sole proprietorships.
- Starting a venture with others? You’re entering a partnership.
- Sole proprietorships and partnerships have profits taxed as personal income, subject to self-employment taxes.
- Transitioning to an LLC offers legal separation without altering tax status.
- S-corps provide a salary and profit distribution, with self-employment taxes levied on the salary portion.
- C-corps face a flat 21% tax on profits and distribute dividends, which are taxed as investments.
Selecting the right business structure is a strategic decision that impacts your financial landscape. Whether your business model dictates your structure or you have the flexibility to choose, it’s essential to align your choice with your financial goals and business strategy.
Sole Proprietorship: The Straightforward Path
The default option for solo entrepreneurs, a sole proprietorship, is the epitome of simplicity. If you’re the sole owner and haven’t designated another structure, this is where you stand. Whether you’re a freelance graphic designer with a roster of clients or a mobile dog groomer, the tax implications are the same.
When you start a business with others, you’re in a partnership. This doesn’t require formal paperwork; for example, launching a lawn care venture with a friend automatically makes you partners.
Even if you form an LLC with multiple members, for tax purposes, it’s still a partnership unless you opt for corporate status.
Partnerships face the same taxation as sole proprietorships, with a twist in filing. Partnerships must submit Form 1065 by March 15th, which is an informational document detailing income, expenses, and the division of these among partners—no tax payment is required with this form.
On your personal tax return, you’ll use Schedule K-1 to report your share of the partnership income, as determined by Form 1065. For instance, if the partnership earns $200,000 and your share is 40%, you’ll declare $80,000 on Schedule K-1.
Your partnership income is subject to the same self-employment tax as sole proprietorships, plus your regular income tax.
Sole proprietorships and partnerships may choose to be taxed as S-corporations, a move that can potentially lower self-employment taxes. To elect S-corp status, file Form 2553 within two months and 15 days of your business’s start date or incorporation. Existing businesses must file by March 15 to apply the change for that tax year, though the IRS may consider late elections.
S-Corp Tax Filing
S-corps file a separate return using Form 1120-S by March 15, serving as an informational report without requiring tax payment. Personal tax filings include S-corp financials via Schedule K-1, or Schedules K-2 or K-3 for international operations.
Unlike sole proprietorships or partnerships, S-corps pay you a reasonable salary for your role. This salary is subject to self-employment and income tax while remaining profits are only subject to income tax.
Consider a mechanic shop with $200,000 in profits. If you draw a $50,000 salary, you’ll pay self-employment and income tax on that amount. The remaining $150,000 is only taxed as income, saving you from the 15.3% self-employment tax on that portion on each shareholder’s personal tax returns. The distribution of profits is outlined on Schedule K-1, which breaks down each shareholder’s portion of the income, deductions, and credits.
The S-corp structure is designed to benefit from pass-through taxation while minimizing the burden of self-employment taxes. Shareholders can receive distributions that are not subject to self-employment taxes, only income taxes, which can lead to significant tax savings.
For example, with the mechanic shop’s $200,000 profit, as an S-corp, you’re only taxed for self-employment on the $50,000 salary. The $150,000 profit distributed to you is taxed at the income tax rate, not the self-employment rate, potentially reducing the tax liability by thousands.
It’s essential for S-corp shareholders to carefully determine a reasonable salary to comply with IRS guidelines and avoid scrutiny. Balancing salary and distributions is a strategic decision that can optimize your tax position.
In summary, S-corps offer a unique opportunity for business owners to manage their tax burden effectively. By understanding and utilizing the S-corp election, businesses can leverage the benefits of incorporation while enjoying the tax efficiencies of a pass-through entity.
A C-corporation stands apart as the most intricate business entity, uniquely responsible for its own taxes. C-corps must file Form 1120 to report their income and calculate tax liability. If on a calendar year, the deadline aligns with personal tax returns on April 15th; otherwise, it’s due the 15th day of the fourth-month post fiscal year-end.
This form accounts for the corporation’s financial activities, with a 21% tax rate applied to profits. For instance, a C-corp earning $1 million faces a $210,000 tax bill.
Ownership of C-corps varies, ranging from a single individual to numerous shareholders. Your stake could be 100%, or you might share ownership with partners or public shareholders, as seen with large corporations.
As an employee of your C-corp, you receive a salary with standard tax withholdings, and the corporation covers half of your Social Security and Medicare taxes. Dividends, however, are treated as investment income on your tax return, not subject to self-employment tax, and taxed at varying rates based on your income and filing status.
Your choice of business structure dictates your tax obligations and the forms you’ll file, shaping your fiscal responsibilities.