Small Business Types & Their Tax Implications
Small Business Types & Their Tax Implications
Gregg Wind (Partner, Wind Bermer Hockenberg, LLP) gives expert video advice on: Can starting a business decrease my taxes? and more...
What are the primary types of business structures?
Business structures vary. Business entities are generally formed as self-proprietorships, partnerships, limited liability companies, or corporations. The type of business that you have and the type of assets that you hold could probably be a deciding factor in which business structure you ultimately choose.
What is a "sole proprietorship" and what are its tax implications?
A sole proprietorship is a business, that's usually owned by a single individual, that isn't incorporated, and sole proprietorships usually report their income and their expenses on Schedule C, which is part of the federal 14, the personal tax return. Sole proprietors generally have to deposit their taxes on a quarterly basis, and the onus is on the business owner to figure out what they actually owe. Generally, if you're a sole proprietor, you may not enjoy the same liability protection you would if you were incorporated. Corporations, for the most part, and I'm not a lawyer, but for the most part corporations protect you or limit your liability to the assets inside of the corporation. Sole proprietors sometimes have personal or unlimited liability, but you should check with your attorney to find out for sure.
What is a "partnership" and what are its tax implications?
A partnership is what we call a pass-through entity. That means that the income from the partnership walks over and is taxed on the partner's individual tax returns, or corporate tax returns, because we can have corporate partners as well. A partnership can be a limited partnership or a general partnership. With a general partnership, the partners have pretty much unlimited liability. With a limited partnership, there is usually one or more general partners and the rest limited partners. And limited partners are generally only liable up to the extent of their investment in the partnership.
What does "liability" mean in the context of forming a business?
When we talk about “liability,” in the context of forming a business, we generally mean liability for product malfunction, liability for services, professional services, that are maybe not up to snuff, or liability for an error or an omission.
What is a "corporation"?
A corporation is a separate legal entity that files its own tax return. You report your income and expenses on the corporate return. Some corporations pay their own taxes, and some don't.
What are some advantages of incorporating?
There are many advantages to having a corporation. For one, corporations will oftentimes have lower rates of audit than sole proprietorships; not always, but oftentimes. It is a separate entity that requires a separate tax return, but it can afford some protection from liability, and it can also allow the business owner to pay taxes through payroll withholding, as opposed to depositing quarterly. Payroll withholding is deemed as being paid in timely as long as it's paid by the end of the year. So a lot of business owners like that particular feature.
What are some disadvantages of incorporating?
The primary downside to having a corporation is the cost of administration. There's an extra tax return to prepare and extra corporate minutes to prepare, but do go through the analysis and see if the benefits of incorporation outweigh the costs - often they will.
What is a "C" corporation and what are its tax implications?
A "C" corporation is a separate legal entity. A C Corporation is also a tax paying entity. The C corporation pays tax on its net income. The C Corporation's tax is assessed at graduated rates, in 2007, up to 35%. The states, generally, will assess taxes on "C" corporations as well. There are restrictions on the number of shareholders that an "S" corporation can have but there are no such restrictions on the number of shareholders a "C" corporation may have. When looking at publicly traded corporations, for example, they are always "C" corporations because of the number of shareholders. "S" corporations can work. Currently 75 or less shareholders are permitted for an "S" corporation.
What is an "S" corporation and what are its tax implications?
An S corporation is very different from a C corp, and the biggest difference is that the S corporation doesn't, by itself, pay tax- it's what we call a "pass-through entity." The income is passed through to the shareholders, sometimes corporate, sometimes individual, and the tax is assessed at that level. Certain states, as in California, where I am, assess a small tax on S corp income, but generally, S corporations are pass-through entities.The other significant difference between S and C corporations is that S corporations limit the number of shareholders that are allowable, whereas C corporations do not. In 27, the limitation on S corp shareholders is 75.
Which businesses are good candidates for S corporation status?
A good candidate for an “S” corporation would be an entity that holds a significant number of assets like real estate. If, for example, individuals are considered real estate professionals, those real estate losses would pass through to shareholders in the S corporation and the shareholders may be able to benefit from deducting the losses.
What is a "Limited Liability Corporation" and what are its tax implications?
An LLC is almost a hybrid between a partnership and a corporation. The partnership part comes from the fact that income is passed through to the members of the LLC, much like an S-Corporation and a partnership. The corporation part relates to liability. LLC members often enjoy similar liability protection to corporate shareholders. In certain states, like California where I practice, state jurisdictions assess fees based on gross receipts. Here in California, the fees can be as high as $11,000 a year. And again, it is based on gross receipts, not net income. So you should be sure to check the rules in the state in which you form your LLC or in the state in which you operate. If you happen to have an LLC that was formed in Delaware, for example, but you own rental property in California, the state of California may likely asses a fee against your gross rents. So you should be sure to check with the state jurisdiction that you either operate in or that you were formed in, because fees are often assessed against gross receipts, not net income. So you could owe money, even if you have a loss.
What is a "personal services corporation" and what are its tax implications?
A personal service corp. is a, generally, a corporation that loans out the services of a doctor, a lawyer, an architect, a CPA. Those are professions, among a few others, that the regulations specifically mention. Personal service corps. are very different from regular corporations in that net income is taxed at the shareholders', or owners', highest rate. Currently, the highest federal rate is 35%. So the first dollar of income from your personal service corp. would be taxed at 35%, not at graduated rates as a regular corporation would.
Can starting a business decrease my taxes?
Starting a business can lower your tax liability, but keep in mind that there always has to be a profit motive and a business motive for starting a business. You should not generally start a business just to reduce income taxes. In fact, businesses that show losses for a consecutive number of years - generally three - could be subject to scrutiny, and taxing authorities could determine that in fact a business doesn't exist, that a hobby exists, and deductions are not allowed for hobbies. So for example if you collect stamps and you try to start a business in it, and don't earn any money for three years running, you could run the risk of having related business expenses disallowed because the taxing authorities could determine that it's really a hobby. You promote business motive if you have business cards, if you're actively meeting with people who can bring profit to you, if you're advertising; those go a long way to proving that you do have a profit motive.
What is the "hobby rule"?
The hobby loss rule generally applies when you have a consecutive number of years when you report losses, generally on a Schedule C sole proprietorship arrangement. While the rules exist, they're not absolute. If you can show that you do have a profit motive, you can go a long way toward preserving business deductions that would otherwise be disallowed if you were deemed to have a hobby and not a business. The things that can promote that profit motive are whether you have business cards and letterhead, and whether you're advertising, and whether you're meeting with people that can bring profit to the business.