Managing taxes, easy right? As a business owner, taxes can become a wholly different maze when compared to personal taxes. The type of entity that you structure for your company, as well as the hiring of employees, will affect the paperwork you need to file and the type of taxes owed. Before you accelerate the day-to-day operations of your business, take a few moments to contemplate the unique tax entity being created by your business.
This is a 2-part series on business taxes. This first installment will be an overview on the different types of incorporation structures. Part 2 will explore the categories of business taxes at the Federal, State and Local levels.
Disclaimer: Please note this article does not represent legal or tax advice as laws are subject to changes. Seek assistance from a certified professional regarding your specific business situation and tax strategy.
What is the first step to start my business? Determine a business structure.
To establish a business, an owner must decide on the structure for their business and follow the incorporation steps for their business structure with the Arkansas Secretary of State’s Office.
Let’s review the different options:
Sole Proprietorship (Self-employed)
Started a business but haven’t filled any paperwork? Congrats, you are a Sole Proprietorship!
With this structure, there is not a registration step with the Secretary of State Office. As a sole proprietor, you will file an IRS Schedule C to report business income and expenses. This will be filed with your personal taxes at the end of the year.
With this structure, it is highly recommended to separate business financials from your personal financials. Consider establishing a separate bank account for the business as it will reduce time wasted analyzing revenue and expenses during tax season. Also, this will prevent any delays and mistakes if there is an audit of your business as the IRS would need both your personal and business records. Also, an Employee Identification Number (EIN) may be required to open a business bank account and will be mandatory if the business has employees.
This can be a good choice for a low-risk business in the testing phase. There are two downsides with this structure: The owner must pay a self-employment business tax plus income tax on personal income and a sole proprietorship does not protect the owner’s personal assets from business liabilities. For example, a homebased baker made a pie with an ingredient that made someone seriously ill. If that customer filed a lawsuit, the baker’s personal assets would be used to cover any liabilities owed.
If you are an independent contractor, freelancer, or provide services in the Sharing Economy, any money you earn must be reported as taxable income. Report the income you earned from your side hustle and any 1099-K or 1099-NCE forms you receive on the Schedule C income form.
A partnership is a simpler structure for a business with two or more co-owners when compared to a Corporation. There are two common types of partnerships: Limited Partnership and a Limited Liability Partnership. In both structures, profits are passed through to personal tax returns. In a Limited Partnership, only one partner, the general partner, has unlimited liability but greater control of the company. This general partner must also pay self-employment taxes. The Limited Liability Partnership is different because it provides liability protection to all partners. This protection separates the business assets from the personal assets of the partners. Using the baking example, if a pie company sold a pie the made a customer ill, only the business assets would be claimed in the event of a lawsuit. The personal assets of the partners would be protected.
Limited Liability Corporation (LLC)
An LLC can be owned by a single owner (single member LLC) or a group of owners. An LLC provides a layer of personal liability protection to the business owner(s). This structure helps to separate your personal assets from being at risk in case your business faces lawsuits.
This structure is unique in that it is created by state law. If it is a single member LLC, it will be classified by the IRS as a sole proprietorship for federal tax purposes with business income and expenses reported on a Schedule C form. If there are two or more members, it will be classified as a partnership. Business income and expenses for a multi-member structure are reported on IRS Form 1065 and Schedule K-1.
To be taxed as a pass-through entity and lower the self-employment tax obligation, an LLC can elect to be taxed as a sub S corporation by completing IRS form 2553, Election by a Small Business Corporation. This must be filed within 75 days of incorporating the LLC. If the 75-day deadline is missed, the owner can still elect a late election on their tax form when filing.
A corporation is a more complex form of business organization with only 5% of businesses incorporated as one. This structure faces double taxation on profit in the form of a corporate income tax of 26.1% (21% Federal and 5.9% State) as well as income taxes to shareholders (owners) on the dividends that are received. Corporations and LLCs that elect to be taxed as a corporation file IRS form 1120.
An S Corporation is a hybrid between a corporation and a partnership. Profits are passed through the business to the owners and are taxed on the owner’s individual income tax returns. S Corporations skip the corporate income tax. Another difference is that an S Corporation has a limit of 100 shareholders and can only be owned by U.S. Citizens (not corporations or partnerships).
Small Business Income Tax Filing
The option that you choose for your business will determine what tax return forms to file. Check out this table from communitytax.com to determine what IRS forms you will need for income tax filing. Check out part 2 for information on additional Federal, State and Local Taxes for Small Businesses.
AR Secretary of State Doing Business in Arkansas Guide
Landmark CPAs Small Business Guide to Selecting an Entity Type