When you started your business, you settled on a legal format to use: sole proprietorship, partnership, limited liability company (LLC), S corporation or C corporation. Entity choice affects not only your personal liability protection in case of legal actions against your company -- it also affects your taxes.
From different tax forms and deadlines to how much you pay to Social Security and Medicare, it can all get a little confusing come tax time. What's the best way to sort it all out? Here are five things you need to know.
1. Different structures require different tax forms.
The tax return you use and your deadline for filing depend on your entity selection.
- Sole proprietor. File a Schedule C for the business, along with your personal Form 1040. Form 1040 (including Schedule C) is due April 15 each year.
- Partnership. The partnership files Form 1065, which includes a Schedule K-1 stating the share of partnership income and deductions for each partner. Form 1065 is due each April 15. Schedule K-1 should be sent to each owner by this date.
- LLC. With one owner, you follow the rules for a sole proprietorship. If there are two or more owners, follow the rules for a partnership. Note: LLCs can opt to be taxed as corporations, but this is not usually done, and further discussion of LLCs assumes that no corporate election has been made.
- S corporation. File Form 1120S, whether you have one or more owners. The return is due March 15. At that time, you must also provide each owner with a Schedule K-1 showing the share of corporate income and deductions for each owner.
- C corporation. File Form 1120, whether you have one or more owners. The return is due March 15. There are no Schedule K-1 requirements for a C corporation.
If your business can't meet the filing deadline, you can obtain an extension of time to file. The period of the extension and the form used to make the extension request depend on your entity type. If you are a:
- Sole proprietor and one-owner LLC, you can obtain a six-month filing extension to Oct. 15. Use Form 4868 to request this extension.
- Partnership and multi-owner LLC, you can obtain a five-month filing extension to Sept. 15. Use Form 7004 to make your request; enter the code for your entity type.
- S corporation and C corporations, you can obtain a six-month filing extension to Sept. 15. Use Form 7004 to make your request; enter the code for your entity type.
2. How you report income and expenses also differs.
A sole proprietor (and one-person LLC) pays tax on profits from the business on a personal return, and losses are also taken here (find details in IRS Publication 334). Owners of pass-through entities -- partners, LLC members and S corporation shareholders -- pay tax on their share of business income on their personal returns, while losses are also reported on their personal returns. Note: There are limits on claiming losses. Information about partnership returns is in IRS Publication 541 and S corporation information can be found in the instructions to Form 1120S (the 2010 instructions are not yet available).
C corporations are separate taxpayers, as explained in the instructions to Form 1120. They are taxed on their profits and can deduct losses, subject to certain limits. Owners of C corporations only pay tax on their personal returns on salary, dividends and other taxable amounts distributed to them.
3. Certain structures provide more favorable tax treatment.
It's not unusual for owners of small businesses to pay out-of-pocket for some company expenses, especially when the company is short of cash. Assuming the company does not reimburse the owner, entity choice dictates how the owner can write off what he or she has paid.
- A partner deducts these expenses as an above-the-line deduction (no itemizing of personal deductions is required).
- A shareholder in either an S or C corporation is an employee, so unreimbursed expenses can only be deducted as miscellaneous itemized deductions. Only amounts exceeding 2 percent of the owner's adjusted gross income can be deducted. If the owner is subject to the alternative minimum tax (AMT), all benefit from the write-off is lost, because miscellaneous deductions are not allowed for the AMT.
4. Social Security and Medicare taxes can vary.
If you are incorporated and work for your corporation, S or C, you receive a salary for your efforts. FICA (comprised of Social Security and Medicare taxes) is levied only on salary (and taxable benefits) to an employee.
In contrast, self-employed individuals -- sole proprietors, partners and LLC members -- are subject to self-employment tax on their net earnings from self-employment, namely all profits, whether or not distributed to owners. Self-employment tax is made up of both the employee and employer share of FICA. Thus, self-employed individuals can pay substantial Social Security and Medicare taxes even if they leave funds in the business.
Note: There are some tax experts who argue that LLC members should not be taxed on all their net profits, but the IRS has not yet issued guidance on the matter. Also, Congress has been discussing a change in the treatment of S corporation owners to make them taxed like partners for Social Security and Medicare tax purposes, although nothing has been decided yet.
5. Your business structure may increase your audit risk.
Believe it or not, how you set up your business can affect the chances of being audited by the IRS. Sole proprietors are the most vulnerable group -- those with gross receipts of $100,000 to $200,000 had a 4.2 percent audit chance during the government's 2009 fiscal year. Compare this with an audit rate on S corporations of 0.4 percent during the same period. One reason for this is the fact that a study on the government's Tax Gap (the spread between what it collects and what it thinks it should be collecting) showed sole proprietors as a group that tended to underreport income and overstate deductions.
The original version of this article appeared on AOL Small Business on 2/16/11.