Lessons for Small business owners – You and your tax returns
Starting a business.
It is no secret that everyone would like to own their own business. Owning a business comes with certain responsibility. Businesses, however small requires a firm knowledge in legality requirements when forming your company with regards to federal, state and local compliance. Each entrepreneur should at least know the basic elements in of this process. This will not only protect you from liability but it is also a basis to start a conversation with your legal team or your accountant.
To help you in that process, here are a few basic facts:
- Check what federal requirements are for your business and make sure you are in full compliance
- State and local requirements. You can visit your local county offices and inquire of any legal compliance that is necessary for your conduction particular business
- Choosing your business structure which we will focus on in the rest of this this article
Business Structure Comparison Table
| Business Structure | Advantages | Disadvantages |
| Sole Proprietorship | Default setup for single owner business which requires little or no paperwork; owner has total control; profits pass through to personal tax return | No separation between business and personal liability; poor vehicle for raising money from investors |
| General Partnership | Default setup for multi-owner business which requires little or no paperwork; owners can divide control as they see fit; business profits pass through to owners’ personal tax returns | No separation between business and personal liability; possibility of partner conflicts; poor vehicle for raising money from investors |
| Limited Partnership | Provides partnership structure but also makes it easier to raise external capital | Limited partners have no control in the management of the business |
| Limited Liability Company (LLC) | Protection from personal liability; less record-keeping than Corp; profits and responsibilities can be easily divided among members | Not appropriate if you want to raise venture capital or investor money. Entire income of LLC members are subject to self-employment tax contributions, which you can avoid with a Corp (Medicare and Social Security) |
| C Corporation | Protection from personal liability; easy to raise capital; seen as an established entity | Costly to form; double taxation; extensive paperwork requirements |
| S Corporation | Protection from personal liability; Profits pass through to owners’ personal tax returns | Only some companies eligible; more limits on issuing shares |
- Based on the above summary table and your business activity, pick the one that most suit your situation
- In a nutshell, two important factors that you need to consider are: Liability – protection from personal liability and your Bottom line – that is your tax consequences
Limited Liability Corporations – LLC’s
This structure is widely chosen by most small business as it provides protection from personal liability, reporting requirements are less than a corporation and profits and losses can be divided as shareholders chooses to. The profits and losses flow through to the individual shareholder. The IRS allows LLC’s to be taxed in four different ways.
4 Ways an LLC can be treated for tax purposes:
- Sole proprietorship (for single-member LLCs)
- Partnership (for multi-member LLCs)
- S Corporation (single-member or multi-member LLCs)
- C Corporation (Single-member or multi-member LLCs)
- Since an LLC is not considered a taxable entity by the IRS, most LLCs are taxed on their personal tax return. The default tax treatment for a single-member LLC is as a sole proprietorship. The default tax treatment for a multi-member LLC is as a partnership
- As an LLC, you don’t have to accept the default tax treatment. Instead, you can elect to be treated as a C Corp or an S corp. Below, is a brief description of each of these types along with their federal tax reporting requirements
- Sole Proprietorship (Default tax treatment for single-member LLCs)
For tax purposes, a single-member LLC is by default treated like a sole proprietor. All business income, deductions, and credits must be reported on Schedule C, which will carry over to the owner’s personal tax return. In addition, the owner must also pay self-employment tax on their net earnings. We will discuss filing details in the Tax Filing requirements for a single-member LLC section of this article.
- Partnership (Default tax treatment for multi-member LLCs)
For tax purposes, a multi-member LLC is by default treated like a partnership. All income, deductions, and credits of the partnership must be reported on Form 1065 and pass through to the partner’s personal tax return. Similar to the single-member LLC, each partner is responsible for paying self-employment tax on their net earnings. To learn more, read the Tax Filing requirements for a multi-member LLC section of this article.
- S Corporation
As we mentioned above, an LLC can elect to be treated like an S Corporation for tax purposes. To elect S Corp status for an LLC, you need to file Form 2553.
An S Corp is treated like a partnership for tax purposes. All income, deductions, and credits of the S Corp are passed through to the owners on Schedule K-1.
- C Corporation
An LLC can also choose to be treated like a C Corporation for tax purposes. By making this election, the business will be recognized as a separate and legal entity for tax purposes. This means that all business earnings would be taxable to the corporation and not passed onto the owner’s personal returns. To elect C Corp status for an LLC, you need to file Form 8832.
Below, is a summary of the tax forms that you need to file based on the choice of LLC selected.
LLC Tax Returns Required for a Single-Member LLC (Sole Proprietorship)
A single-member LLC that is taxed as a sole proprietorship is required to complete & file both of the following tax forms along with their personal 1040 tax return:
Schedule C (Profit or Loss from a Business) – Schedule C is the tax form used by sole proprietorship to report all income and expenses for a business.
Schedule SE (Supplemental Income or Loss) – Schedule SE must be filed by a single-member LLC that chooses to be treated like a sole proprietor for tax purposes. This schedule is for reporting self-employment income. Net earnings of $400 or more must be reported on Schedule SE and filed with your personal tax return.
LLC Tax Returns Required for a Multi-Member LLC (Partnership)
Multi-member LLCs that are taxed as partnerships are generally required to complete & file the following three tax forms:
Form 1065 (U.S. Return of Partnership Income) – Partnerships are required to report all income, deductions and credits of the partnership on Form 1065. This form is filed for informational purposes only which means that there is no tax due. As mentioned previously, taxes are paid at the partner level based on their share of income, deductions and credits reported on Schedule K-1(Form 1065).
Schedule K-1 (Partner’s Share of Income, Deductions, and Credits) – Since partnerships do not pay taxes as an entity, the income and expenses generated by the partnership must be paid by each partner. Each partner’s share of the partnership’s income and expenses is provided on Schedule K-1. Each partner must report this information on his/her personal tax return using Schedule E.
Schedule SE (Self-Employment Tax) – Each member of a multi-member LLC that is taxed as a partnership is subject to self-employment tax on net earnings of $400 or more. To calculate self-employment tax, complete Schedule SE and file it with your personal tax return.
LLC Tax Returns Required for an LLC that elects to be taxed like an S Corp
An LLC that elects to be treated like an S Corp for tax purposes is required to complete and file the following tax forms:
Form 1120S (U.S. Income Tax Return for an S Corporation) – Form 1120S is used to report all business earnings for an S Corporation. An S Corp is not considered a taxable entity, which means all income and expenses generated by the business must be reported on Form 1120S and passed through to the members of the LLC on Schedule K-1 (Form 1120S) to be reported on their personal tax returns.
Schedule K-1 (Shareholder’s Share of Income, Deductions & Credits) – Since S corps do not pay income taxes as an entity, the income and expenses generated by the S Corp must be paid by each shareholder. Each shareholder’s share of income and expenses is provided on Schedule K-1 (Form 1120S). Each shareholder must report this information on his/her personal tax return using Schedule E.
LLC Tax Returns Required for an LLC that elects to be taxed like a C Corp
An LLC that has made the election to be treated like a C Corp for tax purposes is required to complete & file the following tax form:
Form 1120 (U.S. Corporate Income Tax Return) – Form 1120 is used to report all business earnings for a C Corporation. Since a C Corporation is viewed as a taxable entity by the IRS, all income and expenses generated by the business must be paid by the business.
Choosing Your LLC Tax Treatment: Pros & Cons
There are a number of factors to consider when making the decision to be treated as a Sole proprietor, Partnerships, an S Corp or a C Corp for tax purposes. Each business structure is unique, and the tax laws change quite often. Therefore, you should seek the advice of a CPA or tax attorney who can evaluate your business and help you make this decision.
| Tax Treatment of LLC | Pros | Cons |
| Sole proprietorship | No double taxation | The owner must pay self-employment tax on net earnings. |
| Operating losses can reduce owner’s tax bill. | ||
| Tax rates based on individual tax rates which may be lower than corporate tax rates. | ||
| Partnership | No double taxation | Each partner must pay self-employment tax on their share of net earnings. |
| Operating losses can reduce each partner’s tax bill. | ||
| Tax rates based on individual tax rates which may be lower than corporate tax rates. | ||
| S Corp | No double taxation | S Corp will be responsible for paying unemployment tax and FICA taxes for wages paid to owners who draw a salary. |
| Owners can reduce taxes by drawing a salary | Strict rules around filing paperwork on time could result in the loss of S Corp status. | |
| Operating losses can reduce each owner’s tax bill | ||
| Tax rates based on individual tax rates which may be lower than corporate tax rates. | ||
| C Corp | Considered a taxable entity. All taxes on net earnings are paid by the corporation and not the owners. | Double taxation |
| No self-employment tax is applicable. | Owners cannot reduce taxes by drawing a salary | |
| Operating losses will not reduce owner’s tax bill. | ||
| Tax rates are based on corporate tax rates which could result in higher tax bill. |
Consider the following when electing how you want your LLC to be treated for tax purposes:
- No Double Taxation for Sole Proprietors, Partnerships, & S Corps
Sole proprietors, partnerships and S corps do not have the “double taxation” issue that C corps have. All income and expenses are passed through to the owners of these 3 entities and taxed once. However, when it comes to a C Corp, all profits are taxed at the corporate level and then again when profits are distributed to each shareholder in the form of dividends. This is called double taxation.
- Treatment of S Corp and C Corp Owners as Employees
The owners of an LLC taxed as an S Corp can also be treated as employees of the company and draw a salary. This is a benefit to the owners if the LLC is profitable and they have high social security and Medicare taxes. The employer portion of social security and Medicare tax (also known as FICA) will reduce the amount of net earnings that will pass through to the owners, resulting in a lower tax bill.
While owners of a C Corp who are involved in the day to day business can draw a salary as well, the owners will not benefit from a reduction in FICA since the corporation (not the owners) will pay taxes on the net earnings of the company.
- Treatment of Operating Losses
If an LLC taxed as a sole proprietor, partnership, or S Corp reports a loss, this loss will pass through to the owner’s personal tax return, which can result in a lower tax bill. In contrast, a loss for an LLC taxed as a C Corp will just carry forward and offset future earnings of the company.
- Lower Tax Bill
The overall tax bill for an LLC taxed as a sole prop, partnership, or S Corp could be lower than a C Corp since the taxes for these 3 entities are based on the individual tax rate of the owner as opposed to a corporate tax rate like the C Corp is.
- No Self Employment Tax for a C Corp or an S Corp
One major benefit of an LLC taxed as a C Corp is that a C Corp is a taxable entity. This means that all income, deductions, and credits generated by the company are paid and reported by the corporation. However, sole props and partnerships are not considered taxable entities. Therefore, net earnings pass through to the individual owner’s personal tax returns which requires self-employment taxes to be paid on those earnings.
Other Obligations for LLC Taxes
- In this article, we have focused on federal income tax requirements for an LLC. However, you may be subject to additional taxes
- In most states, LLCs also have to pay state income taxes. If you live in one of the 7 states that does not have a state income tax (Alaska, Florida, Nevada, S. Dakota, Texas, Washington, Wyoming), then lucky you! For those not so fortunate, you will report and pay taxes for your LLC to your state just like you do federal taxes
- If you sell products that are taxable, then you must collect sales tax from your customers and report and pay that tax to the state authorities. To learn more about state and local tax requirements, check your state tax agency website
- Some states charge an annual LLC fee known as a franchise tax, registration fee, or renewal fee. Be sure to do your research on what taxes an LLC is required to pay in your state and find out what additional fees an LLC is required to pay
The Bottom Line
As a business owner, it is important for you to understand what your tax obligations are at the federal, state, and local levels.
