Eric Tyson - Small Business Taxes For Dummies

All corporations actually begin as so-called C corporations, which are the corporations discussed in the section “ Deciding whether to incorporate” earlier in this chapter. To become an S corporation, your business must go through an additional “tax election” step. See IRS Form 2553, “Election by a Small Business Corporation.”

U.S. tax laws allow most, but not all, small businesses to be taxed as an S corporation. To be an S corporation in the eyes of the almighty IRS, a company must meet all the following requirements:

Be a U.S. company

Have just one class of stock

Have no more than 100 shareholders who are all U.S. residents or citizens and aren’t partnerships, other corporations, or, with certain exceptions, trusts

Be sure to investigate limited liability companies (LLCs), the subject of a later section, before committing to forming an S corporation. LLCs offer the passing through of income that S corporations do and are generally simpler to initiate and operate. As the operator of an LLC, you can still have the future option of converting to an S corporation.

A partnership occurs in the eyes of the tax authorities when two or more people — the general partners (GPs) — operate a business together and divide the profits (or losses). The division need not be done equally.

The GPs are responsible for the company’s debts and liabilities. A partnership may also have limited partners (LPs) who generally provide financing to the business and who aren’t active in the company itself. Most small-business partnerships don’t have LPs.

A partnership is similar to a sole proprietorship and other pass-through entities for income tax purposes. Partners pay personal income taxes on their share of the partnership’s income distributed to them. This is done on IRS Form 1040 Schedule E, “Supplemental Income and Loss” (see the first page of the form in Figure 2-3; the complete form is available at www.irs.gov/pub/irs-pdf/f1040se.pdf ). As sole proprietors do, partners pay self-employment taxes on income earned.

Though the partnership itself doesn’t pay any federal income tax, it has plenty of federal income tax reporting requirements. In fact, the tax rules and reporting requirements of a partnership are quite extensive and challenging. The partnership must file IRS Form 1065, “U.S. Return of Partnership Income.” And the partnership must complete and annually issue IRS Schedule K-1 of Form 1065 to each partner. You’d be well advised to use the services of a tax advisor if you’re going to have your business function as a partnership (see Chapter 13for the scoop on getting help).

Courtesy of the Internal Revenue Service

FIGURE 2-3:Page one of IRS Form 1040 Schedule E, “Supplemental Income and Loss.”

In recent decades, a new type of corporation has appeared. Limited liability companies (LLCs) offer business owners benefits similar to those of S corporations and partnerships but are even better in some cases.

Like an S corporation, an LLC offers liability protection for the owners — hence the name limited liability company. In addition to the veil of overall liability protection for the owner’s personal finances, an owner’s liability for business debts is limited in an LLC to their percentage ownership share in the business.

LLCs also pass the business’s profits through to the owner’s personal income tax returns, like a sole proprietorship or partnership. You can pass through losses as well and deduct them against your other income so long as you materially participate in the business.

LLCs are generally much simpler to set up and administer than a corporation. But, to be realistic going into it, don’t expect an LLC to be as simple as a sole proprietorship. And LLCs don’t give you the ability to tap into some of the tax advantages (for example, specific fringe benefits) that some corporations offer.

LLCs have fewer restrictions regarding shareholders than S corporations. For example, LLCs have no limits on the number of shareholders, and the shareholders can be foreigners, corporations, or partnerships.

Compared with S corporations, the only additional restriction LLCs carry is that sole proprietors and professionals can’t always form LLCs (although some states allow this). All states now permit the formation of LLCs, but most state laws require you to have at least two partners for an LLC to be taxed as a partnership and not be a professional firm.

Single-owner LLCs (which also include married couples in community property states) are treated as sole proprietorships and file Schedule C of Form 1040 for tax purposes, unless the owner elects to file as a corporation on Form 8832, “Entity Classification Election.” A domestic entity that has more than one member will default to a partnership. An LLC with multiple owners can either accept its default classification as a partnership, or file Form 8832 to elect to be classified as an association taxable as a corporation. This form is for informational purposes only. Keep in mind that LLCs aren’t taxed federally; income is passed through to the company’s owners/shareholders. However, numerous states levy a tax on LLCs and require an annual tax filing. Some states like California go even further with fees. California has a fee based on gross receipts, not net income. A California LLC with $500,000 in gross receipts pays $820 tax plus a $2,500 fee for a total of $3,320, even if it reports a net loss for the year after expenses.

Who doesn’t like a free lunch?

Well, in this section, I don’t actually tell you how to get a free lunch or two, but I do explain how small businesses can offer their employees valuable benefits. These “perks” or “fringe benefits” are usually tax-deductible expenses for the business and often tax-free to the employees. Another plus for the company is that — unlike wages paid to an employee, which cost the business in Social Security, Medicare, and unemployment taxes — benefits can save the company on these taxes.

A small-business owner — or any business owner, for that matter — should never provide a particular employee benefit just because it’s tax-deductible. Keep in mind that you have to spend money to qualify for a deduction, and the value of that deduction only recoups part of the outlay the company makes to provide a particular benefit. Providing benefits to your employees can and should be motivated by these factors:

Offering an industry-competitive compensation package: You compete for employees with other companies in your line of work. If most competitors offer health insurance and a retirement savings plan, you need to know that as you design your benefit package. From a cost standpoint, you need to track and manage the total cost of the compensation package, which includes benefits provided to employees.