Rules related to small businesses are complicated and can be scary. Deductions, and credits and other tax benefits -- OH MY. Where do you start?
First, you must choose which type of business structure or entity you will be. Then, you can worry learn about the tax considerations based on the entity you chose. In this blog, we will discuss what your entity options are related to how you are taxed. Next week, we will cover some of the tax considerations available to you.
There are important tax and operational considerations specific to each type of entity. Tax considerations include when and how to report income including specialty tax deductions such as the home office deduction, start-up expense considerations, payroll, benefits, health insurance, and even special depreciation deductions. We are focusing only on HOW and WHERE YOU ARE TAXED here. Operational considerations such as legal protections, liability issues, and even state rules and regulations are another matter.
There are typically three different choices when it comes to setting up a business entity - a Sole Proprietorship, Partnership or an S Corporation. These are the most common and while other more complex entity choices do exist, including a full C Corporation, we are keeping to the simple and commonly used.
A Sole Proprietorship is the easiest and most common type of business entity because no real organizational or set up activity is required. This business is owned and operated by an individual and reported on Schedule C, Profit or Loss from Business (Sole Proprietorship) with their Form 1040, U.S. Individual Income Tax Return. A sole proprietor has no legal requirements for the business, does not need a lawyer to set it up, and only needs a federal identification number for the business if there are employees other than the owner. Individuals who are sole proprietors pay self-employment taxes on their net profit from the business in addition to the other items included on their individual tax return. Though it is the easiest to set up it has the least legal protections.
The next most common type of small business is a Partnership. Partnerships are formed when two or more people invest in, or simply agree to operate together, and run a business. A partnership generally requires a legal agreement between these owners (partners), but the agreement can be very informal. A Partnership is considered a separate tax entity from the owners, therefore must have a federal identification number -- even if the only employees are the partners. Partnerships file a separate tax return, IRS Form 1065, Return of Partnership Income, and each partner receives a Schedule K-1 (Form 1065), Partner's Share of Income, Deductions, Credits, etc. reporting their share of taxable income and deductions, or business operation loss, from the partnership. Like sole proprietors, partners are subject to self-employment taxes on their share of net profit from the business. Slightly more complicated than sole proprietorship, a partnership is still easy to set up and, even with the separate tax return, is a good, simple structure to run a business from, especially if the business has two or more partners that share in the business both financially and otherwise.
Finally, there are Corporations. If you incorporate there are several options to consider, but the S Corporation is the simplest and most common of corporate business structures. The S Corporation is its own entity, much like the Partnership, and files a tax return, a Form 1120S, U.S. Income Tax Return for an S Corporation. In the S-corporation, the profit from the business is passed through to the owners and investors on a Schedule K-1 (Form 1120S), Shareholder's share of Income, Deductions, Credits, etc., and taxed on their personal returns - also similar to a partnership. If you choose to set up your business as an S Corporation, you will not pay self-employment taxes on your profit because you pay Social Security and Medicare taxes through withholdings on your compensation received like any other employee.
Choosing the type of entity to run your business has many implications, only one of which is the tax consequences. As noted above, there are a lot of considerations. It takes brains, heart, and nerve to start a small business, but you don't have to be a Wizard. It is always best to consult a small business professional or tax professional for more details before you make any final decisions regarding your small business.
In our next piece, we will cover some of the specialty tax considerations and even deductions and tax credits that are available to small businesses.