A primer on business structure choice and tax obligations
Those who are starting their own business have a long list of questions and considerations to discuss before choosing the appropriate structure. One area that requires careful consideration is that of taxes. The chosen business structure will impact how much you pay in taxes and the required paperwork to file with the Internal Revenue Service (IRS). This piece will briefly discuss the tax implications that come with some of the more common business structures.
#1: Sole proprietorship
Sole proprietorships are known for their freedom. They are easy to form and give complete power to the owner. When it comes to taxes, the owner of a sole proprietorship will generally report income from the business on their personal income returns as well as a Schedule C. They will also need to report self-employment tax on Schedule SE.
A partnership itself does not pay income tax. The income tax in this type of business structure passes through to each partner. The IRS expects the partners to report their share of income on their personal tax returns. Necessary forms often include a Form 1065, U.S. Return of Partnership Income as well as the Schedule SE noted above.
As far as the IRS is concerned, a corporation is its own taxable entity. This is the first business structure in this discussion that operates this way. As such, it can fall subject to double taxation. The IRS taxes the corporation on its profits and the shareholders on their dividends.
There is an exception: the S corporation. The S corporation structure allows the corporation to pass income, losses, deductions, and credits to its shareholders. This bypasses the double taxation issue noted above. There are strict criteria to qualify for classification as an S corporation. These criteria include that the business is domestic, have no more than 100 allowable shareholders and not be ineligible. Ineligible corporations include insurance companies and certain financial institutions.
There are various types of corporations, and the chosen type will impact the details of tax obligations and which forms are needed. However, in general, the IRS expects most corporations to use Form 1120 to determine their income tax liability and report their income, gains, losses, deductions, credits.
#4: Limited liability company (LLC)
It is important to note that thus far this discussion focuses solely on federal tax obligations. State and local obligations may also apply and impact your choice of structure.
This is noted now because it is relevant to the next business structure, the LLC. The LLC is a creature of state law. Each state has its own rules that guide how to form as an LLC. Depending on the details of its formation, the IRS may treat it as a corporation, partnership or a disregarded entity that is part of the business owner’s tax returns for federal tax purposes.